Numerous studies indicate that most investor’s returns (often including the institutional investors) lag the market. Some investors lose more than others and along those same lines, some often lose enough for multiple investors.
Is it because of a lack of higher education? Do they lack raw intelligence? The answer is “no” to both of those questions. Most investors possess not only a college degree (and often advanced degrees) but also plenty of raw intelligence to earn decent returns.
So what’s the problem? Where do they break down and fail? It’s not brain power that is causing them to fail, it’s a breakdown in investment behavior triggered by negative induced emotions.
Below are a few highlights of poor investment behaviors that sabotage the long term success of investors.
As easy as it is to hear the words, “Buy low and sell high,” that is not what happens. As crazy as it sounds, the equity markets defy the basic laws of economics. (Kindzia, are you crazy? Did you just say the stock market defies the laws of economics?) Yes, and here’s how. The basics of economics revolve around the laws of supply and demand. Looking at a basic demand curve, what we should witness is a negatively sloping curve. What this implies is that as the price of goods and services rise, demand should fall. Think about a pound of lobster for a minute. If the price of lobster goes up to $100 a pound, demand should fall off a cliff. But if the price of lobster were to drop to $3.99 a pound, demand should be much higher. As price increases, demand decreases. Got it? Good.
Now, let’s look at the cycles of the equity markets (stocks). What happens on the extremes of the demand curve? As the prices of stocks increase (think strong bull market), demand increases (people want some of that fast easy cash.) Investing is great, and simple and it’s easy money. It is so easy your Grandmother can day trade and earn annual returns over 25%! To repeat; as stock prices increase, demand increases (WHAT THE?!?!)
Now let’s move to the other extreme. What happens in a big bear market? Stock prices decrease. And what happens to demand? You got it, it shrinks.
If you want proof, we could look at cash inflows and outflows in mutual funds. Cash inflows into mutual funds are often at their highest at the top of bull markets. For the month of October 2007, when the S&P 500 ended the month at its highest month end value of 1,549.38, cash inflows into mutual funds were +$24,558 billion for the month (with a “B” kids). One year later as prices dropped and the S&P 500 was 37.5% cheaper, cash outflows for the month of October 2008 were -$127,988 billion (that’s minus $128 billion with a “B”).
Humans are an emotional bunch. And unfortunately for too many of them, they make investment decisions based on these emotions and their “feelings” rather than crunching numbers or using logic. Further, their feelings often sway them into making decisions based on what the market recently was rather than where the market is going. They “zig” after the market already “zigged” and then once they’ve zigged, the market “zagged” and left them waiting for a bus that never came.
Markets move in cycles (albeit very difficult to predict cycles) but investors aren’t necessarily doing themselves any favors during these cycles. Case in point, at the end of February 2009 when the S&P 500 closed at a end of month low of 735.09 in comparison to the month end high of 1,549.38 back in October of 2007, did investors line up to buy low? Absolutely not! They sold their equities and moved into bonds.
For the month of February 2009, equity (stock) mutual fund outflows were -$25,029 billion while total bond mutual fund inflows were +17,152 billion. And we see negative investor behavior in action at its worst. The market “zigged” and moved to lower prices. Investors reacted in the short run and then “zigged” themselves after the fact. The key to successful investing is not going where the market just was but rather where the market will be. If an investor was really apt at timing markets, the time to sell equities and move into bonds is not at the bottom of the cycle, it’s at the top. The time to sell all of your equities and move into bonds wasn’t February of 2009, it was October of 2007!
So now where does that leave an investor? Should they be loaded up on bonds and cash right now? I’d be willing to say, “Probably not.” If we go back and think about cycles, ask yourself this, “Assuming you can’t time the absolute bottom of markets, (just like we can’t time the top of markets), make the question a bit easier. Right now are we at the top of an economic cycle and stock market cycle?” I think you would be nuts if you said yes to that question.
If we are not at the top, would it be fair to guess and say that we are closer to the bottom of a cycle than the top of a cycle? And if we are at the bottom of a cycle and prices are low, should we be invested for our long term in bonds when the 10 year Treasury bill is yielding a pathetic 2.75%? Will you hit your retirement goals if you yielded 2.75% over the next 10 years?
Further, bond prices rise while interest rates fall. Likewise, bond prices fall when interest rates rise. What is the risk return model of owning bonds in this interest rate environment? How much lower can interest rates go when they are already down to practically nothing? So best case scenario, you yield the low interest rate. Worst case scenario is that you locked up at a low yield and rates move upwards and the bonds depreciate in price. Not a lot of investors are taking this into consideration as they ran from the equity markets.
Finally, do we really want every investor buying stocks at the bottom of the cycle? No, there always needs to be a buyer and a seller to make the sales transactions happen. If we want to be the ones buying when prices are down, we need able and willing sellers at lower prices. Think about it this way, if we really want to buy something at a great value, we need people to act irrationally and sell us valuable things at a discount.
Investors seem to always claim that they are long term investors. I guess we should probably have them define what “long term” means in their minds. I think of long term in terms of decades (or at least years). But if we look at the trading practices of most investors, their idea of long term investing isn’t even six years but more like six months, six weeks or often only six days.
The time to buy stocks for the long term is now.