The psychology of why investors "Buy High/Sell
Low," and how to avoid that trap
For 2009, the S&P 500 gained 26.5%, the Dow
Industrials gained 22.7%, the NASDAQ gained a phenomenal 45.4% and
Barclays Aggregate Bond index gained 6.1%. European exchanges gained 24-32% while
Brazil, India and China returned once in a life time gains of 82.7%,
92.6% and 118.7%. These were the
best results for world stocks since 2003, which, not coincidently, was
also the first year following the last bear market. Yet millions of investors failed to
participate in these gains.
Why? Because they panicked
at the worst possible moments last January, February and March, went to
cash and have stayed in cash.
Those investors will never make up the gap and will be lucky to
retire ever!
Not all our clients could "stay the
course." About a half dozen
fired us the first week of March and liquidated their portfolios at 13
year lows. Another half dozen
liquidated their portfolios between July and October 2002 at the tail end
of the last bear market. However,
a number of our clients moved excess cash into their investment
accounts during the crisis.
We took those clients fully invested by April, and they picked up
hefty gains in nine months on those investments.
At least in US stocks, there's never been a bear market
that wasn't followed by another bull market. We can imagine scenarios where stocks
don't recover after a bear market.
Those scenarios generally involved investors foraging for food
among smoking cities following a nuclear war, for example. In any scenario where McDonald's still
sells hamburgers, GE still sells power plants, JP Morgan still dispenses
cash from ATM's and Pfizer still sells Viagra, we would be highly
confident that the market will recover.
What information can we, as investment advisors, give our clients
to enable them to stand strong during the next bear market?
The DALBAR Quantitative Analysis of Investor Behavior
DALBAR is a market research firm that compiles a bi-annual
survey of investor behavior. We
would be delighted to forward a copy of the full 2009 survey on
request. DALBAR analyzes the flows
of retail investors' funds in and out of mutual funds as a proxy for
overall investor behavior. For the
20 years ending 12/31/2008, the S&P 500 gained 8.35% (all numbers
annualized), the Barclays Aggregate Bond index gained 7.43% and inflation
gained 2.89%/year. So by simply
buying an S&P 500 index fund January 1st, 1989 and holding
that fund through all the crises of the next 20 years, an investor could
have earned nearly 5.5% real return.
The real value of their money gained 289% over 20 years -
practically a triple!
However, investors actually held mutual funds on average
only 3-5 years, either jumping out to cash or jumping into hot sector
funds, usually after the big gains were already in the bag (think of
Internet funds circa 1999.) As a
result, the average investor returns in mutual funds over the same 20
year period was 1.87% for equity funds, and 0.77% for fixed income
funds. Adjusted for inflation,
typical investors lost money over the 20 year time frame
Quoting directly from the DALBAR study:
Why Investors Do What They Do
The principles of behavioral finance help explain why
investors often make buy and sell decisions that may not be in their best
interests, in both the long and short term:
Loss
aversion: Expect
to find high returns with low risk
Narrow
Framing:
Making decisions without considering all implications
Anchoring: Relating to familiar experiences,
even when inappropriate
Mental
accounting:
Taking undue risk in one area and avoiding rational risk in others
Diversification: Seeking to reduce risk simply by
using different sources, giving no thought to how such sources interact
Herding: Copying the behavior of others
even in the face of unfavorable outcomes
Regret: Treating errors of commission more
seriously than errors of omission
Media
response:
Reacting to news without reasonable examination
Optimism: Believing that good things happen
to "me" and bad things happen to "others"
End quote
Take a moment to consider the implications of these principles
to your own investment experience.
In particular, we are always intrigued how many of our clients
want to invest in "hedge funds" or "aggressively
leveraged, non-transparent, limited liquidity, co-mingled pools of
capital" as we call them. The
marketing of these funds always seems to boil down to the promise of
"high returns with low risk," and this promise is only
available to the "select few."
In the worst case scenario, investors found out that they were
invested with Bernie Madoff. Even
among legitimately operated hedge funds, the mortality rate (closure of
fund because of unacceptable principal losses) was about 20% of all hedge
funds last year. By comparison,
the mortality rate among boring registered investment advisors such as
ourselves was near 0%.
Scenario testing
Much military preparation, whether at level of individual
recruits or at the "war game" level, revolves around training
for likely scenarios. For example,
if a soldier has already practiced dealing with 20 simulated "ambushes,"
that soldier is far more likely to react appropriately and survive a real
ambush. We recently developed a
series of scenarios for our clients and prospective clients to consider
as a way to establish how they really feel about investment risk.
Scenario 1:
You're on a plane preparing land at LaGuardia Airport in
New York City during a thunderstorm.
With minutes to go before landing, the plane is suddenly rocked by
violent down drafts. Do you:
A.
Buckle your seatbelt tighter, clutch
your armrests and toss a prayer to your personal deity.
B.
Rush down the aisle, kick open the
cockpit door and seize controls of the plane yourself.
Scenario 2:
You're at the dentist having root canal. Suddenly, you feel acrid dust on your
tongue and smell smoke. Do you:
A.
Ask for a moment to rinse your mouth
and clear your throat (this will be over soon.)
B.
Grab the drill and finish the
operation yourself.
Scenario 3:
You're a defendant in a major product liability case. If you lose, you could be out $500,000. After two weeks of trial, the case
could go either way. During the
final summation do you:
A.
Rely on your attorney to finish the
trial - win or lose, he's the one who went to law school.
B.
Address the judge and jury yourself.
Scenario 4:
Your three year old car develops a case of
"mushy" brakes and won't stop as quickly as you expect. Do you:
A.
Take the car into the dealer for a
thorough inspection.
B.
Tinker with the master cylinder,
calipers and brake pads yourself.
Scenario 5:
Stock prices have fallen 20% over the last 6 months, and
leveraged investors everywhere are vomiting up securities. On the television, investment analysts
soberly explain how you must hedge your portfolio by "loading up on
the UltraProShares Triple-Short ETF." Your brother-in-law is buying gold and
dividing his cash up among 6 different banks, in case one of them
fails. Do you:
A.
Hang tight, knowing that you won't
draw on your assets in stocks for at least five years, and think about
maxing out your 401K contributions a bit early this year.
B.
Fire your investment advisor
("that idiot!") and convert all your stocks to cash.
If you would select option "B" in any of these
scenarios, please write a few sentences as to why.
Why CNBC is not good for your financial health
Obviously some of our clients chose option B for the last
scenario, even though we're reasonably confident they'd stick to option A
in most professional encounters.
What is it about investing that makes clients suddenly think they
know more than their advisor in the midst of a financial panic? In the practices of medicine, dentistry
or law, or the occupations of airline pilot or mechanic, there's no mass
media devoted to "do-it-yourself" dentistry, legal work,
piloting or car repair. There is
quite a bit of mass media devoted to "do-it- yourself"
investing. You can find personal
finance columns in all major newspapers and websites, there are dozens if
not hundreds of investment newsletters, and of course CNBC plays on the
television screens of every bar, health club, airport departure lounge
and shoe shine stand in the nation.
A typical CNBC story will lead off with "what stock
should you be buying today; what fund should you be buying today; what
commodity should you be buying today?" The proper answer, in our opinion, is
the same stock, fund, commodity that you bought three months ago and will
be buying three months from now, because nothing in the real world ever
moves so frantically as to justify buying and selling in the same week,
day, hour or second. However, that
kind of sober, rational analysis, which would lead to very little
trading, doesn't pay the bills of all the stock brokerages that advertise
on CNBC. So much of the reporting
on CNBC prompts you to "act now!" We prefer the old fashioned
"mosaic" approach, where an investor gathers hundreds if not
thousands of data-points before making a decision. Each data-point is no more significant
than a single tile in a mosaic, but thousands combined together produce a
very pretty picture.
Probably the most ridiculous segment on CNBC is the
"Mad Money" show with Jim Cramer. We think Cramer's a reasonably smart
guy who made a reasonable amount of money for his clients back when he
ran a hedge fund (full disclosure: David Edwards wrote the
"Portfolio Managers Toolbox" column on the TheStreet.com from
1999-2003.) We don't think he can
teach Mr. & Mrs. America to do their jobs, take care of their
families, and simultaneously day trade their 401K accounts.
We do know we can't trade like Cramer recommends, and
what's more, we're pretty sure we don't want to. Cramer has successfully resisted
efforts by independent firms such as the Mark Hulbert Financial Digest (a
newsletter rating service) to actually track his performance over
time. However, our guess is that
at best the performance ballparks around the S&P 500. More likely, he underperforms given the
trading costs and short term taxes that a high turnover trading strategy
entails. Cramer's show is very
entertaining with the camera swoops, props and sound effects. "Scrubs," a comedy about
young doctors, is also very entertaining, but we wouldn't watch that show
to learn internal medicine.
Our performance, by the way is computed monthly, quarterly
and annually, and compared to the relevant benchmark on every client
statement.
No one ever mentions on CNBC that the odds of being a
successful "recreational" investor are about the same odds as
being a successful "recreational" poker player in Las
Vegas. Becoming a successful
investor requires a commitment of 40-60 hours/week devoted to research,
tens of thousands of dollars spent annually on market data, years of
practice and the self-knowledge to recognize that, of the thousands of
investment decisions you make over a life time, 40% will be money
losing. Therefore, do you have the
discipline to truly diversify your investments? Can you buy what others sell, and sell
what others buy?
Do you trust us (and are you honest with us?)
95% of our clients trusted us when we said "stay
invested" through the crisis and were rewarded. Given how their accounts have rallied
in the last 9 months, we expect those clients to start making new highs
(relative to October 2007) over the next two years. Key word is "expect" not
"guarantee." The "real"
economy, as opposed to the "financial" economy is recovering
fastest in emerging markets such as China, Brazil and India, and also in
developed economies such as Australia and Canada where financial game
playing was minimal. The economies
of the United States and Western Europe, with the most sophisticated
financial systems, took the worst hits.
It's pretty aggravating that bankers in the United States and
Europe felt taking record bonuses of about $200 billion this year was
appropriate, even though about $10 trillion in wealth was destroyed in
2008-9. So far, it looks like the
world's real economy is recovering even with a crippled financial
economy, and that growth would justify gains in stock prices in the 8%
annual range.
Do you trust us to keep monitoring your investments,
shifting your investments between companies and industry groups, domestic
and international markets, stocks and bonds as our analysis and
expectations see fit? If you
don't, we'd like to hear from you now while markets are calm.
Are you honest with yourself about what's reasonable from
an investment portfolio? Our best
guess is that a properly diversified portfolio of stocks, bonds, mutual
funds and ETF's will return less than 8%/year over the next decade. For years, we told our clients who draw
upon their portfolios for retirement income that 4% (of the total value
of a portfolio) is the conservative annual draw rate and 7% is an
aggressive draw rate. We were
thrilled that we didn't have to cut anyone's "allowance" over
the last year because we required our clients to be conservative when
times were good. A portfolio that
gains 8%/year doubles every 9 years.
A portfolio that gains 20% for 4 years and loses 50% in the fifth
year leaves you right where you started.
Don't ask us to build you a portfolio that will outperform the
S&P 500 in a bull market, deliver money market returns in a bear
market (if there was such a strategy, everyone would follow it.)
Strategy
As we proceeded
with our transformation to a wealth management firm, we concluded that we
can't rely completely on our clients to educate themselves about
financial matters (everyone has a busy life, and let's face it, most
financial journalism is a good cure for insomnia.) In addition to our monthly market
commentaries, we will also distribute short "strategy" pieces
on topical issues. Over the next
several weeks, look for e-mails on subjects such as "A Financial
Self-Assessment," "The New Roth IRA rules," "Estate
Planning in 2010," "Timing Social Security
Distributions." Also, we'll
be introducing more of our clients to the "Full View" tool on www.Fidelity.com. Some of our
clients are using this tool already, but in brief, "Full View"
allows you to see all your financial affairs, whether brokerage or mutual
fund accounts at other firms, your 401k, checking accounts, debit and
credit cards and mortgages all on a single "dashboard." Good information drives good decisions!
As always, please don't hesitate to call with questions
and concerns.
Yours sincerely,
David Edwards
President
