Roth: Why Investors Repeat Mistakes

Investors claim to understand how they blundered; why do they blunder again?

As investors, we think we learn from our mistakes, but far too often we don’t. Here’s an example.

An investor contacted me looking for help. He was mostly in cash and confessed that he panicked and sold after the stock plunge in 2008 and missed the run-up that began in 2009 that took stocks far higher than the pre-crash levels, as shown below.

The investor told me he’d learned an expensive and important lesson: He was not smarter than the market.

Funds flowed out of stock mutual funds and ETFs through 2012 and only started flowing back into stocks in 2013, after they’d hit an all-time high. He vowed he would never make that same mistake again.

I then went on to describe my philosophy of picking an asset allocation of stocks and bonds and sticking to it no matter what. I noted that this rebalancing meant selling stocks as the real estate bubble heated up though 2007, and buying stocks in 2008 and early 2009, when capitalism was supposedly dead.

What the man said next shocked me, though it shouldn’t have.

He said: “I’m with you on stocks, but I’m not going to buy bonds now.” When I asked why, he responded, “Because rates are at historic lows and have to go up.” In my typically tactless way, I asked, “So you learned you weren’t smarter than the stock market, but still think you’re smarter than the bond market?”

The call terminated shortly afterward, but not before I got in a comment that the top economists listed in The Wall Street Journal surveys have correctly forecasted the direction of interest rates far below 50 percent, the expected accuracy of a coin flip.

Why We Don’t Learn

I discussed this man’s story with Dan Ariely, Duke University professor of psychology and behavioral economics, and author of books such as Predictably Irrational. Ariely explained there’s a big difference between learning a lesson in general and acting on it specifically.

Ariely said we are storytelling animals and we can’t help telling ourselves stories that override the general lesson we think we’ve learned. The story seems logical and appears to explain the future. That prevents us from acting on the general lesson we think we learned.

So the investor in my story paid hundreds of thousands of dollars to learn an expensive lesson only to continue to believe he still was smarter than financial markets. I suspect his research was impacted by confirmation bias on why rates had to go up, and a bond bubble was imminent. I also suspect that in early 2009, he was searching for data on why capitalism was dead and cash was king.

When you make an investment decision, ask yourself if you know something the market doesn’t know.

If the answer is no, then guess what? You’re actually following the herd, and that typically ends poorly.

But let’s say there is some particularly good reason you have to believe you know the future. Make sure before you act on it that you can list at least three reasons why your forecast may be dead wrong.

If you can’t, then you probably aren’t looking at it objectively and may be making a costly investment mistake.

Allan Roth is founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for CBS MoneyWatch.