Why am I more optimistic about the future of the stock market? I can’t help it when I read that mutual fund outflows last year topped $130 billion, or 3 times more than in 2010. Despite the 20% or so rally in the S&P 500 since early October, there were outflows of $28.8 billion in December 2011 alone. The market can be a cruel mechanism designed to inflict damage on the majority of participants. With so many investors fleeing, the market has posted some impressive gains this year. As I write this, the S&P 500 is up almost 7% year-to-date and the Nasdaq 100 is up almost 11%.
Yet every time I encounter a prospective client, they ask, “How have you done since…?” Why do investors continue to focus on the best performing managers from the prior year? Are they “trend-chasers”? Do investors really expect the exact same conditions to prevail the following year? I’m not poking fun, but, can we get real? From 1984 through 1995, the average stock mutual fund posted a yearly return of 12.3%, yet the average investor in a stock mutual fund earned 6.3%.
Professionals and amateurs alike, we are all the same to varying degrees. We are human and subject to the same basic emotions: fear, greed, optimism and regret. We combine our experiences, aspirations, and we find a way to rationalize our decisions in search of investment success.
To answer some of these questions, I turned to my friend, Dr. Alok Kumar of the University of Miami School of Business. Click here to see his homepage. Dr. Kumar is an authority on Behavioral Finance and has written over 40 research papers on the subject. He and his research staff have access to tens of thousands of individual investor records. In their research of investor behavior, they have analyzed the trading histories, the results obtained and have made important discoveries.
Behavioral finance holds that investors tend to fall into predictable patterns of destructive behavior. There are as many as 25 common tendencies, but the most common patterns include: frequent trading, following the herd, selling winning positions and holding onto losing positions, overconfidence and anchoring.
Overconfidence. 19% of people think they belong to the richest 1% of U.S. households and 80% of students think they will finish in the top half of their class. Active trading correlates highly with overconfidence and can be easily spotted as a major differentiating aspect between men and women. It has been observed that online trading accounts are most common among men. Research has found that women are more inclined to use traditional advisors. It has also been observed that men exhibit worse net performance when compared to female investors.
The disposition effect, that is, the tendency to hold on to losers while selling winners, can have a major impact on portfolio performance. Loss-averse investors sell high-performing investments hoping to recoup their losses on poor performers but, in fact, too often achieve the reverse. People feel pain of loss twice as much as they derive pleasure from an equal gain. In the worst cases, investors end up with declining account values and higher capital gains taxes. Successful trade management requires a disciplined approach to managing gains and losses.
Herd mentality is driven by a desire to be part of the crowd. This is how bubbles are formed. It happened in the dot com era, the housing bubble, the gold rush and now in the bond market. Perhaps it is hard for human beings to stand still when all around us are taking action. As a professional, there’s an incredible amount of pressure to maximize client wealth. The problem with bubbles and investment fads is the amount of scrutiny that money managers receive from clients who suddenly notice or hear about the new hot investment if they are not involved.
Anchoring bias is the well documented tendency of people to rely too heavily on one piece of information, (anchoring on that one thing) when making a decision. All the other information is there, but it is not equally weighted in the decision making process. For example, assume someone purchased a home for $500,000 at the peak of the market and is now trying to sell his home in a depressed real estate market. He is reluctant to list or sell his home for less than $500,000 because he is emotionally anchored to that ”value” for his home. When investors exhibit the anchoring bias, they are unwilling to accept new information that is contrary to their the view. Another example is when you refuse to buy an investment because it was cheaper in the past. This is all too common in portfolio management. As a portfolio manager begins to deploy cash after identifying an attractive investment, they may stop before reaching a full allocation in that investment because the price has risen. Warren Buffet missed out on a $10 billion gain in Wal-Mart because he became anchored on the price. He said, “That thumb-sucking, the reluctance to pay a little more, cost us a lot.”
Famed investor Benjamin Graham once said, “Individuals who cannot master their emotions are ill-suited to profit from the investment process.” We at Alhambra Investment Partners are driven to better understand and identify the behavioral influences on our investment decisions. It is a fascinating area of finance that deserves serious consideration in your investment process.
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joseph Gomez can be reached at firstname.lastname@example.org.
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