Let’s face it: The past decade and more has been horrible for most investors.
This is not necessarily because the markets have been rocky, but rather because the vast majority of investors are hardwired to do three things that kill returns.
You can blame Washington, the European Union, debt, high unemployment or half a dozen other factors if you want to, but ultimately, the person responsible is the same one staring back at you from your bathroom mirror in the morning.
That’s why understanding the bad habits you didn’t know you had can be one of the quickest ways to improve your financial wealth.
Here’s what I mean:
Dalbar, a Boston-based market research firm, produces annual research that compares the returns of stock and bond markets with those of individual investors. And the latest report shows that the average equity fund investor underperformed the S&P 500 by 7.85% in 2011.
And fixed-income investors didn’t do any better. In other words, investors’ self-defeating decisions contributed to this underperformance, which has taken place for the last 18 years.
Three reasons: recency bias, herd behavior and fear.
It’s All About Perspective
Recency bias is what happens when short-term focus trumps long-term planning and execution. It’s what happens when somebody yells “fire” and everybody runs for the same exit at once despite having entered through any of half a dozen doors in the auditorium. Simply put, recency is recent knowledge that overrides longer-term thinking and memory.
This is why momentum trading works, for example, or the news channels seem to cover the same stocks at nearly the same time — because a huge number of people are focused on exactly the same companies simultaneously. Logically, they then become the subject of increased attention and tend to move more strongly or consistently.
The question of “why” is the subject of much debate among human behaviorists, but I chalk it up to the fact that human memories tend to focus on recent events more emotionally than they do longer-term plans that are put together with almost clinical detachment.
And the more extreme the events or the news, the sharper our short-term focus becomes.
That’s why, according to Mood Matters, a book by Dr. John Casti, one of the world’s leading thinkers on the science of complexity, “bombshell events are assimilated almost immediately into the prevailing (social) mood,” whereas longer-term cycles bear almost no witness to gradual change.
If that doesn’t make sense, think about what happened on 9/11. Most of the world’s major markets bottomed within minutes of each other on short-term panic and emotion. Then, when trading resumed days later, they began to climb almost in sync as highly localized events once again faded into the longer-term fabric of our world.
And that brings me to herding.
The Herd Mentality
We’d rather be wrong in a group than right individually, so the vast majority of investors tend to make decisions, and mistakes, together en masse.
You can see that in market data suggesting we have a fine tradition of doing exactly the right thing at precisely the wrong time. Instead of buying low and selling high, most investors tend to sell low and buy high, further damning themselves to sub par returns.