By Gary Silverman, CFP®
Today marks the end of our two-month look at what makes smart people do dumb things with their investing. It grew from my interpretation of a Vanguard study on the value of financial advisers. According to that study, one of the major contributors of an adviser’s worth is keeping clients from reacting to the market based on emotion rather than education and logic. I called this reaction “doing something dumb” in the first article of this series.
No, I wasn’t trying to insult the American populace; I saw it as just a description of humans being humans. Most humans are not dumb; but all humans do dumb things.
In the first and second articles, I also explained how Recency Bias, the tendency to assume that what has recently been going on will continue to do so, caused people to believe that the bull market of the ‘90s would continue. We learned how Overconfidence made them think that when their investment performed well, it’s because of their brilliance even if it was just coincidence (remember all of the day-traders?). And we found out how Herd Mentality brought those on the sidelines into the game resulting in a rather big tech bubble.
Then in week four we saw how Herd Mentality shifted from euphoria-laced Overconfidence that brought people into the market to Risk Aversion and Recency Bias that chased them out.
In week five we saw what happens when markets start to recover. Though more subdued, the market’s subsequent rising starting around 2003 meant Recency Bias, Overconfidence, and Herd Mentality would come into play again. But this time it wasn’t stock investors who were doing bad things, it was those in real estate and banking. Recency Bias made them think that real estate would go up forever, which their profits showed that whatever system they were using must be good and proper, and Herd Mentality buoyed the confidence of those involved because “everyone was doing it.” Though they don’t mess up quite as often as individual investors do, you’ve got to admit, when the big-boys mess up, they certainly go big. This combination shattered the world’s economy, leading to the Great Recession.
So what do you do with all this information?
When you invest know that while there is a tendency for markets to continue in a particular direction (we call this momentum), you don’t want to give in to Recency Bias and assume away the fact that the market cycles. Instead, be ready for the inevitable cycle.
Know that you don’t know. You haven’t figured out the magical formula to predict the market. You never will.
Don’t follow the herd. Yes, it could be running away from a wildfire to a nearby stream, but it is more likely to be lemmings running toward a cliff. Investors tend to move in tandem more at market peaks and troughs doing the exact opposite of what will make them money.
When it comes to Risk Aversion, do not ignore it. It is going against your natural risk personality that will cause you to do something dumb.
Knowing where the dumb dangers lie will allow you to be a smart person doing smart investing.
This article was published in the Wichita Falls Times Record News on Octover 9, 2017.