Behavioral Investing

Successful investing is a complicated process. From an intellectual standpoint, it does require some study of company’s history and financial statements but it is not rocket science, nor does it require a master’s degree from a big name business school. The hard part is the emotional component of an investment decision, which requires a good deal of patience and the ability to ignore most of what currently passes as generally accepted wisdom.

A study compiled in 2008 By Dalbar Inc. showed that over the previous 20 years the average annual return of the stocks in the S&P average was 9%. During the same period, the average return of the average Mutual Fund was 8% the difference probably the result of fees and commissions. However, the average mutual fund investor earned only 3% per year. How is it possible those investors under-performed their mutual funds by 5% per year, and why when sitting and holding an index fund would have returned 9% did the average investor do only 3%?

The answer, I suspect, is not that complicated. Twenty years of managing other people’s money leads to the conclusion that it has little to do with intelligence, and everything to do with the investor’s emotion. While it is not particularly difficult to pick a good investment (find a well-managed companies with a durable competitive advantage) or if that is too much trouble, to buy the low fee index fund. The hard part is sitting quietly as the market slowly turns totally irrational.

Investors work hard to accumulate investable assets, and during a bear market as they watch the value of their portfolio decrease week after week it is easy to confuse volatility with risk. The point to remember is the distinction between intrinsic value (what the business is really worth and market value (the price quoted daily by the irrational Mr. Market). Contrary to the belief of efficient market theory most of the day-to-day movement in stock prices is based on noise and has little relation to the actual value of the company.

A the problem complicated by the fact is that people instinctively sense  they will improve their returns by paying attention, and while this would seem to be a good idea, the problem is it tends to generate activity that based an emotional reaction to an irrational market. For instance an exit based on fear when the news is bad and prices are making new lows.

”Most people simply don’t have the biological makeup to buy low, hold on and sell high,” says James Grant , editor of the respected biweekly publication Grant’s Interest Rate Observer, “There is an almost irresistible human urge to do the opposite.”

Bear markets like Bull markets do not go on forever, but bear markets tend to end at a point in time that most investors are convinced that stocks are going much lower. A good investment advisor can benefit an investor if he can keep his clients’ money in the market in a bear market when the client’s instinct is to exit. Invariably at market bottoms, there are calls from clients who just want to get out because they are tired of watching the value of their portfolio decline day after day. My best advice is to tell them to turn off CNBC and go to a movie, or better yet take a 10-day cruise to the Caribbean.

Complicating the emotional difficulty of investing is the market’s volatility, and the fact that investors confuse volatility with risk. Most volatility is generated by investors overreacting current developments and measures the impact of investor’s emotion on prices. Very little of this emotionally generated volatility has anything to do with investment.

Stocks are more volatile than bonds, but to assume that bonds are there a safer investment because they are less volatile is to ignore the history of the last century were underlying economic fundaments, and so in no way is a reflection of the risk of a particular inflation and taxes have eaten away most the returns of any fixed income investment. The fact is that in the long run fixed income investments in an inflationary environment may offer less volatility but carry a higher risk of real loss of purchasing power, and so offer only an allusion of safety for investors saving for retirement.

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