Risk Factors and Behavioral Traits of Individual Investors Part II
We’ve been here before and will see it again. The markets are bumping up against record highs, GDP data for prior quarters are stronger than anticipated, the market publications are turning increasingly bullish, and investors are beginning to get excited about the potential for returns. Compounding the situation are the year-end reports and statements demonstrating a 25% or greater return in 2013 for the Russell 2000, S&P 500, and Wilshire Total Stock Market compared with flat lining Emerging Markets and Fixed Income benchmark Barclay’s Aggregate (AGG).
Is now the time to buy? Is this market real? Should I sell my Emerging Market fund and buy the Russell 2000 or S&P 500? Should I move money from bonds and safe havens into the market?
These are the common questions individual investors struggle with as the realization of missing another market rally sets in, or as they weigh shifting from underperformers to winning sectors and regions. The bad news is the same mistake is often repeated. The good news, it doesn’t have to be. As President of Indelible Wealth Group, Jason Brooks CFP® AIF® partners with investors to establish a disciplined investment strategy and build lifelong skills to weather the next storm.
Behavioral Finance has long been discussed amongst the economic community to more effectively understand why people react emotionally in buy/sell actions. In 1759, Adam Smith touched on the subject in “The Theory of Moral Sentiments”, in which he proposed psychological explanations for individual behavior. In fact, the field is so well explored that institutional money managers often base buy sell decisions inversely of the individual investor (they tend to sell when the investor is overly bullish and buy when overly bearish).
To this point, the American Association of Individual Investors posts an investor sentiment barometer (www.aaii.com) gauging the bullish/bearish sentiment of their members.
(At the time of this writing 12/20/2013: Bullish 47.46% Neutral 27.46% and Bearish 25.08%)
A few of the more challenging behavioral traits facing investors are (but not limited to):
- Loss Aversion
- Narrow Framing
- Home Bias
- Return Chasing
Typically during market peaks, the last two tend to be the most frequently repeated behavioral traits, and the problem isn’t limited to novice investors. In today’s posting I will explore chasing returns. In subsequent writings I will expand upon the other topics.
In the July 2006 NBER (http://www.nber.org/digest/jul06/jul06.pdf ) an article titled “Do Mutual Fund Investors Care About Fees?” James Choi, David Laibson, and Brigitte Madrian highlight the tendency for investment decisions to focus on returns as opposed to the cost of investing with index funds. In the study, investors were given $10,000.00 and told to invest across 4 index funds but only shown the performance of the funds (in part 1) and then shown performance and fees (in part 2). The results were intriguing, participants in part 1 purchased the funds with highest returns and in part 2 (even with knowledge of fee structures) preferentially placed money in funds with the highest trailing 12 month returns, instead of evaluating and investing based factors such as costs. Remarkably, the subject of the experiment were a mix of Harvard and University of Pennsylvania College of Business Undergraduates and University of Pennsylvania MBA students, which simply demonstrates that really smart people can make very poor choices when it comes to investing.
So what is wrong with their decision? In their 1985 study “Does the Market Overreact”, Werner De Bondt and Richard Thaler demonstrated the tendency for “Loser’s Portfolio” to outperform the “Winner’s Portfolio”. This occurs because investors tend to overreact to the market environment. In essence, investors rush in during the boom times, and flee at the peak of a crisis because of the perception of never ending doom. (See Journal of Finance, Volume 40, Issue 3 pages 793-805, July 1985).
Another interesting point: In the mutual fund industry it is common for 5 star funds to outperform to the downside (lose more) during corrections. This happens because 5 star funds typically attract a greater share of fund inflows at market tops, and therefore have more selling pressure during the final capitulation of the market correction.
Does this mean you shouldn’t purchase a 5 star rated fund? Not exactly. What matters is following a disciplined methodology on buy/sell decisions. Factors such as management tenure, style drift, cash inflows and outflows, and turnover ratio (to name a few) should carry greater weight in your decision making process than the ratings of the fund.
The plight of the Individual Investor is characterized as a series of overreactions with often financially catastrophic results. Of the greatest threats to success, the individual’s mental approach to investing plays a tremendous role and only through establishing a disciplined approach will you break the cycle of emotional decision making. By working with a trusted fee only financial advisor you will develop good investing habits to last throughout your life and build confidence to weather future market storms.