Managing Irrational Investment Decisions

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Managing Irrational Investment Decisions
Managing Irrational Investment Decisions

Financial pundits everywhere talk and write about how an investor’s mindset can have a significant effect on wins and losses – true statement.  However, my belief is that poor decision making doesn’t start with irrational thinking, it starts with irrational investments.

I recently read, The Behavior Gap, a book by Carl Richards, which talks about this very subject, rational versus irrational investing behavior and how it affects returns. The takeaway solution promoted the need to have a financial advisor available to make up for investors committing the grave mistake of irrationality. The book, The Power of Zero, by David McKnight, touches on the same idea. Though both books presented excellent points about investing in general and risk management, in my opinion, there is a discrepancy.

The Behavioral “Norm”

When investing, we’re taught to buy low and sell high. This simplistic, straightforward advice makes complete sense if we as investors always have perfect information about where the markets is headed.  If we did have perfect information, even the novice investor could make accurate predictions. So, though the buy low and sell high advice are words most investors live by, it’s extremely unrealistic.

The Behavioral “Reality”

Let’s take 2008, for example. As the market declined, investors bailed out of the market in droves, much like rats from a sinking ship.  Analysts say the fear resulting from the housing market crash was the reason for it, and the behavior was irrational.

Why irrational?  Because everyone knows the market would eventually find its bottom and rebound.  Then, those same investors who jumped ship on the way down, were some of the last to jump back in as the market charged to new highs in early 2013.

The result for the average investor was the exact opposite from the stated goal of buying low and selling high.  Many ended up selling low, then buying high.  This result is what financial advisors point to as investors acting irrationally.


Investor vs Investment

In my opinion, buying high and selling low in 2008 did not happen because of irrational behavior, it happened because of irrational investments.  It turns out that it was the best decision any investor knew how to make.

Ex Post Facto Advice

Investors take action as market events unfold. We don’t have the privilege of “waiting out” the market as it bottoms. Yet this is exactly how investment advisors want us to act.

Because our retirement is on the line, we as investors have to look at situations in the market from the perspective of, “what are the costs to me if the market continues to go down versus my potential benefit if rebounds and comes back up?” Obviously, the cost of losing everything is greater than the potential of making incremental gains, so we draw a line in the sand and say if my portfolio falls below “x”, then I have no choice but to protect what I have left.  This is why we sell on the way down.

Buying back in has its own set of challenges.  Because we hold on as long as we can before exiting, we can’t just jump right back in as soon as we see the green bar shoot upward.  We have to ensure that those seeds of recovery have taken root before we can manage more risk with our diminished nest egg.  We wait. We wait until our confidence is high enough to justify the risk.

The problem with financial advisors is that now, in 2015, they can look back and see where the market bottomed out and rebounded.  Thus they conclude that clients who sold and bought back in acted irrationally because of evidence that surfaced after the fact.  Many people talk about irrational behavior, but they do so as if they know, for a fact, exactly where the market is headed, be it up or down.

The Nikkei Index

Why is acting on this advice so dangerous? Let’s look at Japan’s Nikkei Index (Japan’s equivalent of the S&P 500) as an example.  Japan’s stock hit a peak in late 1989. Then the market crashed.  But instead of a quick rebound in a matter of a few years, the Nikkei crashed again. And again. And again.  Ultimately the market found its bottom in 2003.

As of today, in 2015, the index is half of where it was in 1989. Had an investor listened to analysts “rational” advice to stay in for the long run, they would be sitting on losses of 50% and more than 25 years of lost time.

It Can’t Happen Here… Or Can It?

But that can’t happen here right? No one can answer that question with confidence, so I think it unwise to rule it out.  While we haven’t had a 25 year downward stretch, we have had stretches longer than most advisors choose to remember.

Our Dow Jones average took 25 years to recover after it fell in 1929. Another 20 years, from 1966 to 1985, produced no buy and hold returns.  And most recently from 2000 through 2012 the market moved tremendously, but had nothing to show for it after that 12 year stretch.

The Rational Decision

Being a rational investor starts before the market moves. It starts with your investing strategy and where you choose to put your hard earned retirement dollars.

If you can’t afford to lose a substantial portion of your income for 10, 20, or even 25 years, then the rational decision is to choose a better asset class. In doing so, you will find the investment control you knew you always had, and no one can accuse you of being irrational.

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