Standing, left to right: Branch Manager Don Harrison, Financial Advisors John Barnes, Amy Taylor, Paul Burdett, Brian Ernest Seated: Client Service Assistants Karen Harrison, Amy Harrison, Pat Rene, Zineb Leizear
Pogo was a long-running comic strip about the misadventures of a cast of swamp critters in the Okefenokee. Its title character, a possum, coined the phrase, “We have met the enemy and he is us.” He was talking about man’s impact on the environment, but he could have been referring to how investors’ emotions hurt their portfolios’ performance. This problem has led to the creation of an area of study—behavioral finance—that seeks to show us how we can improve our investment performance by understanding what we are doing to sabotage it. Three behaviors which drag down our returns are “herding,” “recency,” and “loss aversion.”
Herding: Our survival instincts tell us to follow our neighbor’s lead, but confident investing means buying an investment at a low point when fellow investors shun it. In contrast, investing with the herd can translate into “buy high—sell low.” For example, a study by DALBAR compared the performance of the S&P 500 over a 20-year period to the performance of the average stock investor during the same time. It’s not good news: $100,000 invested in the S&P on 1/1/89, would have grown to $292,329 by 2009. However, $100,000 invested on the same day by the average investor would be worth just $82,288 at the end of the same period (both figures are adjusted for inflation).
Recency: The “recency effect” means that we are more influenced by what’s happened lately than by what’s happened over the long run. When a certain asset class has performed well, we tend to believe it will continue to do so, even though history suggests otherwise. This contributes to bubbles like the ones in housing and tech stocks, because making an investment decision based on recent performance means we ignore value and drive up prices to levels that don’t make business sense.
Loss Aversion: Investors are very sensitive to potential losses. When shown a distribution of one-year returns which contain a number of negative years, investors typically allocated 40 percent to stocks. When shown a distribution of 30-year returns with no negative periods, investors usually allocated 90 percent to stocks.
According to behavioral finance experts, improving our investment performance starts with a simple acknowledgement that humans aren’t designed to be successful in the markets, but there are things we can do to attempt to achieve better results:
• Define what we really want from our investments and translate that into specific, written goals.
• Create a long-term investment strategy that reflects our individual objectives, and make risk management an integral part of that strategy.
• Identify our emotional biases and consider them carefully before deviating from our long-term investment strategy.
If we accept that we can’t change the markets, the only thing we are left to work on is ourselves. And if we’re successful at learning how to manage our emotions, we could find that whatever the markets do somehow doesn’t seem as important as it once did.
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