Perspectives on Investing – Fourth article in the Perspectives series.

What we have tried to do in this short series of articles is present the most basic attributes that make an investor an efficient investor, and we’ve done that by looking at investing basics from a slightly different view-point—one that emphasizes attitude and behavior.

We have done this because the average investor does not get the returns of the funds he or she is in, and that includes those who use index funds. The goal is clear then, we must behave in an efficient manner to capture what is available to us. A big part of doing that is setting sights on the proper target, and that target is your fair share, not market-beating returns.

As soon as you become discontent with plowing and want to try racing, you increase the number of potential mistakes and end up with more return slippage. Trying to beat the market simply isn’t worth it when you can reach your goals without trying things that are not only likely not to work, they may also produce enough inefficiency to prevent you from getting that fair share.

The investing methods recommended by Bogleheads present the most effective way to invest because they are simple and at the same time more efficient than any other method. The forum attracts new members who aren’t interested in the theory of why it works, and it also attracts highly educated professionals and academics who understand theory quite well. And again, the most insidious obstacle to success for either of these groups is their own behavior.

Application of principles

It sounds easy, just follow the recommendations and stay with it. Easy to recommend, but it is not easy to do. Investors are constantly faced with a challenging market and that makes them think they need to do something different. The great paradox here is that news and events prompt reactions from investors, both professional and individual, and it is investor reactions that ultimately moves the market.

High returns prompt investors to increase their allocation to stocks, and negative news or events, especially surprises, prompt investors to get out, thus creating a drop that can turn into an avalanche. Why does this happen?

High returns

JaneBryantQuinn

Jane Quinn Bryant

As author and columnist Jane Bryant Quinn states:

The green—in our eyes and in other peoples wallets—brings out the worst in us. I don’t mean morally, I mean our worst instincts as investors. We think we make rational decisions. More often, we veer from hope to fear and back again, without putting our brains into gear at all.

Negative news and events

People are hard-wired to protect themselves when threatened with harm, and monetary harm triggers the same response as physical harm—run.

As Michael Mauboussin, managing director and head of Global Financial Strategies at Credit Suisse states :

mauboussin

Michael Mauboussin

“The root of the problem is bad timing. … investors tend to extrapolate recent results. This pattern of investor behavior is so consistent that academics have a name for it: the “dumb money effect.” When markets are down investors are fearful and withdraw their cash.”

Don’t be “dumb money”

Investors can stand by a rule to not make impulsive moves when market volatility is in a range that they are used to, and that’s about two-thirds of the time. But then something happens outside the comfort zone and they react, which results in higher volatility. No matter what they say, investors do not like to lose money and they are not willing to take the risk that it will be only temporary, at least when in panic mode. Even though investors fear losses, they also set themselves up for losses by playing into greed when market returns are high. Note the behavior shown in this article by Carl Richards. The article points out that TDAmeritrade is experiencing record high trading activity.

A recent poll on the Bogleheads board shows 66% of participants support 100% stock allocations, and there seems to be a spreading idea that bonds are currently riskier than stocks. It’s not hard to connect the dots: Bad behavior at work.

Asset allocation and behavior

In a previous article we discussed asset allocation and risk, the risk being market risk and aversion to losses. The range of stock allocations one can have is of course 0 to 100%, and it’s pretty clear to everyone that 0% stock is not acceptable, and it’s actually not investing at all. A low limit on stocks is maybe 20% in a small number of cases where accumulation is completed, but 30% is probably more realistic. In the accumulation phase, 30% stock is usually not enough. Low stock allocations present the real risk of not reaching retirement goals. That seems pretty clear.

You may also recognize an element to investing that confronts every decision. A decision about one thing affects something else. In this case too little stock risk increases the risk of not accumulating enough. On the opposite end, too much stock risk increases the risk of losing what you have already accumulated.

It is interesting to note that while almost all investors see the risk in having no stocks, many don’t see the risk in having too much, especially when retirement is a long way off. The question that needs to be asked is not is it really safe in the long term, but is it prudent. Again, every decision affects something else, and when the depth of negative outcomes are not known, it would not seem prudent to do anything 100%.

Investors look at historical facts and draw conclusions that are not supported. For instance, history shows that U.S stocks have dropped about 50% in every market crash except for one in which it dropped 90%. Do investors assume that a 90% drop can’t happen again, and do they also assume that if it did they would have no problem holding? Also, U.S. market behavior has been better than other countries. Can we assume this will continue?

When trying to determine how much risk to take, it’s worth considering that the risk is ultimately the behavior of other investors when confronted with negative surprises or shock. We already know that mass behavior can seem  irrational and it’s very addictive. Therefore, the best approach to investing should always include a margin of safety just to cover something that hasn’t been considered. It can happen: it will happen. If a portfolio is properly designed, it must include all three major asset classes: stocks, bonds, cash.

Some new investors might have an idea of how they value money, but if they’ve never had to deal with significant amounts of money before, chances are they don’t know. If you don’t have any idea how you might react to your first dramatic market downturn, then maybe 65%-75% stock to start is reasonable. If you are concerned about losses, then perhaps 50% stock is more appropriate. For those more familiar with risk, 80% may be acceptable. You also may begin to feel differently as your accumulated assets reach substantial levels, so a reevaluation at that point might be a good idea.

New investors are faced with lots of short term money needs as they begin a career, get married, buy a house and so on. Since a focus on savings rate is very important during these years, you don’t want to find yourself with a risk level that drives you out of the market in a crash. To help you cope, think of it this way: You will lose money in a crash, but the loss is in the price of your stocks, not in the amount of stock you own–it is still all there. Selling when the market is down locks in loss and that converts what should have been shallow risk and temporary loss into permanent loss. If your timeline is long enough, you can recover from this common and costly mistake, but if you are nearing retirement, permanent loss is devastating. Again, the idea is not to say, I won’t bail out, it is to say, I will hedge that possibility by buffering the risk.

Summary

Pogo

The mechanics of investing are not difficult. John Bogle, the greatest advocate for the average investor, created Vanguard, the only not-for-profit fund company in the world, so we would have a good chance of getting our fair share. Note that our fair share is a very big bite considering the industry built around the stock market is designed to extract a lot of investors’ fair share for their own profit and they are very successful at it.

Mr. Bogle also realized that what prevents investors from getting their fair share once the pathway was developed, is their own behavior. This is also addressed in a quote from the well-known comic strip, Pogo: “We have met the enemy, and he is us.”

Mr. Bogle’s guidelines, reflected in the Bogleheads Philosophy, are designed to minimize costly behavioral mistakes.

Key points:

  • Have a plan
  • Never bear too much or too little risk – Asset allocation limits
  • Keep costs low
  • Diversify
  • Stay the course…and stay the course.
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Posted in Behavorial Factors, Investing
September 2014
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