Our Own Minds – The Biggest Obstacle To Investment Success

Most of us have the belief that we are rational beings, with facts driving most of our decisions.  The reality is, research shows this is not the case.  Behavioral psychologies at many universities have tested out this belief, resulting in conclusion after conclusion that humans are irrational in their decisions much of the time.  Our minds are driven by fear and greed and led by herding, simply meaning that we feel comfortable with a large group who think the same. This is even true when logic does not prevail or evidence to the alternative. If investors would get this, they could be much more successful……
Two prominent university studies were completed at Harvard and Stanford University.A big part of their conclusions revolved around the fact that humans greatest advantage over other species is our ability to cooperate.  In other words, humans were developed to resolve problems presented by the world by living in collaborative groups. In other words, most individuals are followers.

Could this explain fads that make no sense but take hold as individuals follow the small minority leaders?  The investment world banks on this phenomenon as when things get rolling they make sure that individuals are all in, creating massive success. The media will follow this model, unconsciously, together with leaders in society. It is difficult to go against the trend, as community makes you out to be an outsider with no common sense…interesting, as many times taking the opposite view makes you the big winner but it is difficult to do.

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In the studies done at the universities, they determined that individuals would not sway from their beliefs even after given irrefutable evidence.  They did not make revisions to their beliefs.  This contention that people just cannot think straight is shocking but has been proven in thousands of experiments.  In other words, reasonable-seeming people are often totally irrational.

I see this time and time again in the world of investing.  When society led by the investment street and advisors together with the media are positive, the masses become positive with them. Sadly, many times they become this way towards the end of a trend, just at the time where the trend is ending.

Here is a look at consumer confidence which gives you an idea of how confidence works opposite to how stocks perform much of the time:

When were stocks at a peak:  in 2000 and 2007-08.  At this time, consumer confidence was at a peak.  As you can see, the peak was as high as ever recorded in 2000, at the tail end of a technology boom.  The peak just prior to the financial crash of 2008-09, again preceded a massive crash. In each circumstance confidence was extremely high, with few thinking things could go wrong.

I remember back in 1999 when I sold out over a $250 million in client assets out of technology and stocks overall and moved them into bonds. Most thought I was nuts at the time. This was led by my firm, as this move had my income crash (no big deal as incomes in the industry are obscene, so a couple of lean years should be no big deal), as well as clients.  Saying that, my customers never fought me on what to do as I have always had a strong analytical ability to determine how and where to invest.

Yes, I can be wrong but I learned a long time ago, that when I am wrong, minimize those losses and move on.  Market timing is more than possible, it is real. But the challenge to implement it is the psychological side.  Investors always feel like they will miss the next big move and they have been conned that buying and holding long term is the best approach.  It is in a secular bull market but definitely is not in a secular bear market. Have a look:

Secular bears are ugly on one’s wealth. But they could be very beneficial as within each secular bear market are major run-ups (cyclical bull market in secular bear) and crashes (cyclical bear in a secular bear).  Remember, that within secular bear markets, there are generally massive run ups, where great money can be made. Current examples are 2002-07 and 2009-current.  The problem is most people just ride the markets up, then ride them down, inevitably taking losses on their capital.

The chart above shows how painful secular bears are to ones wealth and how positive secular bulls are. You have to invest differently in each paradign.

This is a market timing tool we use.  Each red number is a sign that market became negative and we either get out to cash or buy and inverse fund that makes money as stocks fall.  In this secular bear market, we have seen 5 down phases. Three of them basically broke even (either made a little or lost a little) but the two others were huge gains. They made over 32% and 29% during market crashes.  Not bad as most people rode the market all the way down, sadly many selling when the market was near the bottom due again to psychology. In this case, massive fear.

Let me show you how even the experts have made horrible calls in this current secular bear market:

The blue bars show what the average analyst rating was for the stated year.  The numbers in red show what the end result of the market was.  In six of the years, the market was either flat or down, in some years down big.  The analysts in all years expected the market to go up, and yes we are in a secular bear market where wild swings are expected and highly probable. History shows us that.

So their bullishness rubs off on the media and in turn the masses. It is a formula for loss of capital. So let’s look at a simple formula of how a crash year can impact wealth. Say, you lose 50% in year one and then make 10% per year for the next 5 years. Here is the result:

Start:     $100,000
Year 1:  $50,000                Yearly loss 50%
Year 2:   $55,000                Yearly gain 10%
Year 3:   $60,500                Yearly gain 10%
Year 4:   $66,550                Yearly gain 10%
Year 5:   $73,205                Yearly gain 10%
Year 6:   $80,525                Yearly gain 10%

So from a cumulative perspective, the portfolio lost 50% and then gained 50% over 5 years but the portfolio is still down nearly 20%.  You must also note that this is real numbers and not inflation adjusted. If they were adjusted, the loss would be even greater.

As seen by the red vertical lines, other periods of advisor extreme positive optimism resulted in either stock market corrections. In longer term charts, they resulted in a number of crashes. When optimism was at the bottom was the best time to buy. Yes, this is counter-intuitive but it has been proved out over and over again.

The problem is actually a nice trait of humans, but not a good one for investors. Humans tend to want to gravitate towards pleasure and avoid pain. The believe the masses will lead them there. If everyone thinks things are good they must be good, even if we show proof that they are not. The last few years have been decent, not great, but good, for many investors. For investors, they feel like winners again. The main basic desire of the brain is to move away from the ‘pain’ of the 2007-09 stock market crash, as it just does not feel good.

Many times I will ask an investor, how has your advisor done for you? In recent years, the answer from many has been good or sometimes great. What has been very interesting in my conversations is that there is no consideration given to:

  • How has the advisor performed relative to index performance?
  • Did the investor lose a lot of monies in the 2007-09 crash?
  • What is your 10-year performance, which includes the crash?
  • How much of the portfolio shortfall is due to high fees?

The investor does not have an answer to any of these. Most of the time, answering these questions becomes extremely enlightening. High fees, below market performance, and lack of risk management during the crisis is the common theme. Many are still down over the past ten years. Poor timing is one of the main culprits as well, as many investors sell and buy at the wrong time.

It is critical for investors to have objective tools to decide when to be invested and when to be out. If you don’t, you will fall prey to market psychology.

To be clear, what we mean by this is that at market peaks, people tend to be most optimistic as economies are near their peak growth and stocks have provided good returns. At the bottom of a market crash, market psychology is highly negative. This is when investors just want to sell everything to ‘protect’ some of their net worth. Personal psychology works directly against successful investing.

Don’t let your emotions lose you money!

Matt Sammut