Investor Behavior Part 2

Quick disclaimer: The views put forth in this commentary solely reflect my opinion.

After my latest commentary, a reader asked: “What advice would you give a millennial who saw their parents lose half, or more, of their net worth from the crash (referring to the 2008 financial crisis) by subscribing to this investment philosophy?"

I had three immediate thoughts – the third one being the most important:

1.) Many other readers might be wondering the same thing, so I should share this.

2.) I wondered if they sold at the bottom of the market, or close to it. Because if they didn't sell, they probably wouldn't have lost anything. Instead, they may have watched prices fall, followed by a recovery, and possibly a higher net worth today. In other words, volatile prices do not equal permanent loss unless you sell at the lower prices. With the proper planning in place, his parents likely would have held enough cash, cash like vehicles, or non-correlated1 low risk assets to meet any immediate needs during the crisis, allowing their riskier market based assets to recover.

3.) But even if you have a solid plan in place, that doesn't mean you wouldn’t sell risky assets and take a permanent loss. As Mike Tyson said: “Everyone has a plan until they get punched in the face.” And 2008 was a massive punch of fear. Fear lives in all of us and drives decision making, especially in times of crisis. And this is why understanding human behavior is critical to long term investment success.

When investing, we should be careful of our human emotion. It feels natural to act on emotion -- it is a survival tactic. But it is usually a bad idea when it comes to investing. When we feel we should take action, many times, the right action is actually to “do nothing”. Take a look at this statistic showing investment returns versus average investor returns: for the twenty years ending 12/31/2015, the S&P 500 Index averaged 9.85% a year. Meanwhile, the average equity fund investor earned a market return of only 5.19%. These results are from research done by Dalbar Inc2.

That's a 4.6% difference per year!

One of the main reasons investor returns are so much worse than investment returns is because people often make investment decisions based on emotion. Emotional mistakes are typically what cause the average investor to buy equities when they are high and sell them when they are low.

I believe both mistakes are driven by fear: buying high in fear of missing out on even higher stock values and selling low in fear of a loss of value. Fear is a powerful emotion. Another noteworthy mistake is pulling money in and out of investments in belief that we can time the market. This is usually attributed to our overconfidence – we all think we're above average. But the reality is that the majority of us are not going to time the market without getting lucky. And if we do happen to get lucky once, it doesn’t mean we made a good decision. And chances are the next time won’t be so pretty.

As mentioned before, our emotions cause behavior that feels right. While emotions such as fear helped our ancestors survive in the wild (i.e., fleeing a situation in which they felt in danger), they don't do a whole lot of good when it comes to investing. Awareness of these behavioral urges is a pivotal first step in learning how to ignore them and stay level headed when making investment decisions. But, even if we're aware of the emotions, not acting on them is hard.

This brings us to the last and likely the most critical check on our emotions when making an important investment decision: talk to someone knowledgeable -- such as a financial advisor or a financially savvy friend who isn’t always bragging about his latest genius stock pick (while ignoring the 50 bad picks just before!). The outsider's view usually helps because he or she is not as emotionally invested in your decision. Even Warren Buffet, the most successful investor of our time, usually consults with his good friend and business partner, Charlie Munger, when making investment decisions.

To recap, I believe the critical steps to not let emotion drive investment decisions are:

1.) Have a proper plan in place with diversification3 that includes both non-correlated assets and conservative assets for times of stock market volatility

2.) Be aware of the emotions we will feel when the market “punches us in the face” or when we hear or read someone’s opinion on what the market will do next (no one actually knows by the way)

3.) Talk to a trusted individual before making the decision

1Non-correlated, as it pertains to investing, refers to assets that do not move in the same direction as each other when there are different types of market shocks::

2Dalbar Inc. is a company which studies investor behavior and analyzes investor market

3Diversification does not guarantee a profit or protect against investment loss.

The S&P 500 Index is a broad-based unmanaged benchmark generally representative of the US stock market. The index does not reflect investment fees and expenses, and investors cannot invest directly in the index.

The information provided is general and intended to inform and educate. It is not intended as an offering of any specific products or services, nor to be construed as specific investment, legal or tax advice. Past performance is not indicative of future results. Individual situations can vary, as such; this information should only be relied upon along with an individual assessment in light of your own specific situation. A thorough analysis would consider a variety of factors that are beyond the scope of this commentary and should be applied to your unique situation along with the help of a professional.

Lastly, as noted in the opening line, this commentary was inspired by a reader’s feedback. We appreciate and strongly encourage continued feedback. Knowing what the readers are wondering about allows us to give you more applicable information.