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How Emotional Investing Can Steer Us Wrong

Monday, December 8, 2014

- By Sheila & Rich Jamison -

The Dow Jones Industrial and the S&P 500 Indexes reached new record highs again this week. The NASDAQ Composite also has notched 14-year highs recently. It is within “spitting distance” of also hitting a new record.

Despite both these numbers and GDP showing we’re in our country’s sixth straight year of economic expansion, there are many individual investors who are still reluctant to put money into the stock market. Financial media makes frequent reference to the trillions of dollars still sitting on the sidelines.

The Big Guys vs. the Little Guys

A J.P.Morgan study found that institutions have plowed about $600 billion into mutual funds and ETFs since 2007. At the same time, individual investors have pulled ~$600 billion out of the market. That is, the big investor and the “little guy” have gone in opposite directions.

My first instinct was that most of the withdrawals must have occurred during 2007 and 2008, the worst of the financial meltdown. But these two years combined represent only ~$125 billion, or 20% of the total.

Market Up, Money Out

From the start of 2009, over the next 15 months the total amount withdrawn from the market by the small investor climbed to $200 billion. Keep in mind that the market had bottomed and begun its current rally on March 9, 2009. That is, the market was rallying then.

So Withdrawals Reversed, Right?

No, they didn’t. In fact, the rate of withdrawal accelerated such that another $100 billion came out over the next 15 months bringing the total to the $300 billion. From mid 2011, they accelerated further. These can probably be attributed at least in part to summer market swoons in both 2010 and 2011. But the market was in overall rally mode.

Total withdrawals reached $600 billion in early 2013. They slowed in the face of 2013’s really good market but continued and have still increased by about another $25 billion to the end of October, 2014.

How It Adds Up

In short, retail investors pulled money out of equities during the current bull market. That is, the market (measured by the major indices in the opening paragraph) and the flow of money into it have gone in different directions … for the retail investor.

Are the Big Guys Smarter?

Institutional investors have moved money into them. As noted above, institutions investment total investment is just about a mirror image of the retail investors’ withdrawals. The deviation from a mirror is that institutions show a more steady rate of (positive) money flow, not the varying rates for the negative money flow retail investors generated.

The burning question this raises is why? What difference(s) between retail and institutional investors accounts for this?

No, Not Smarter … Colder

Behavioral Finance is an academic field spawned to study and answer that question and others like it. Behavioral finance, essentially a cross between psychology and economics and still in its infancy, has already made fascinating inroads into the puzzle.

Simple, Once You Know How

Those inroads all seem to come down to this: people have emotions. Emotions lead to biases.

For example, institutions adhere to a more disciplined approach than do individual investors. Both know discipline is important. Why do do institutions remain more disciplined?

In a Word

Emotions. People have them. Institutions don’t.*

Emotions get in the way of logical thinking. Retail investors often (make that too often) permit their emotions to dictate their investment decisions.

Down the Rabbit Hole

Even when we can know something is an X, emotions can override that knowledge. Emotions have an ability to turn our focus from knowledge to feelings.

Though we know better, we may follow that emotional lead in a different direction. Usually, it’s because that makes us feel better. Treating an X situation as a Y instead of an X usually leads to poorer decisions. Emotions frequently underlie a retail investor’s failure to make optimal investment decisions.

Examples

This leads to the behavior examined above … and other phenomena like buying high and selling low.

In contrast, institutions typically follow fairly rigid policies. Those enforce disciplined investing.

Sounds like “Mind Control”

Actually, it is mind control. But it’s not some nefarious outside agent that’s invaded and inhabited our brain. It’s within each of us. And the trick to overcoming it (or at least, to getting along peacefully with it) is knowing that it is happening.

The term assigned to these subconsciously-operating ‘rules’ is behavioral bias. A behavioral bias is a tendency to do something in a predetermined, usually unconscious, way. After all, if we knew we were doing this and at the same time knew it wasn’t logical, we probably wouldn’t do it.

Let My Little Light Shine

Most behavioral biases are easy to understand once we look at them. Overcoming them then takes practice – holding them up to the light of day for introspection.

Two Among Many

Here are just two of the more common behavioral biases. There are dozens, but we have to start someplace. You may even recognize either or both of these pieces of the puzzle in yourself … now that you’re looking at them with deliberate, conscious consideration.

The Availability Heuristic

The “availability heuristic” is a principle that says we make investment decisions based on the most easily or readily recalled events. The more easily we remember something, the more weight it has on our decision making. The more vividly we recall the event, the more power it holds.

Now let’s face it. The 2008 financial crisis certainly is ‘top of mind’ for lots of us. It was unexpected, sudden, big and dramatic. Who doesn’t remember this event vividly?

The result of the availability heuristic is that despite our slow, steady and accelerating recovery, many investors are likely more risk-averse than they were before the financial crisis.

Loss Aversion

Its name already tells you what it is all about. Loss aversion is illustrated by people being more sensitive to potential losses than they are excited by potential gains. The figure that gets tossed around – a rule of thumb – is that we are about twice as motivated to avoid losing $100 than we are to gain it.

This bias keeps investors more focused on how much they could lose rather than on how much they could gain. Emotion puts on the brakes at the loss point. It’s hard – make that impossible – to see past a potential loss if you’re not even attempting to look past that point.

Many More Biases

The list of behavioral biases is at least a couple dozen long now. It seems as if it gets longer each time I read something new. As pointed out before, the field is still in its infancy.

The list of behavioral biases is at least a couple dozen long now. It seems as if it gets longer each time I read something new. As pointed out before, the field is still in its infancy.

No one bias can be credited for doing all of anything. Different biases can be triggered by different market environments. Some exert more influence during good markets; others during bad ones; still others during the boring flat ones.

Strength in Numbers

However, when we begin to string them together, their power multiplies. It doesn’t matter which biases combine or how much power each exerts in the then current conditions. They travel in packs and pack members may change – but packs give them greater strength.

The two behaviors above certainly contributed to investors pulling money out of equities following the large losses many incurred in the financial crisis. I would have to say it was logical then, that is when the markets were tumbling.

But these two biases may well have prevented – and may still be preventing – many of these same investors from benefiting from the subsequent equity rally.

What Should I Take From This?

Understanding investor biases can be an important step toward overcoming them. Overcoming emotionally driven actions can be an important step in achieving better portfolio performance.

Shaking off decision-distorting behavioral biases leaves an investor better able to implement a disciplined investment approach – one based on voices of fact, reason and logic rather than one built on those unchallenged emotional voices in his/her head.

In fact, an important part of our job is to help you ascertain who it is you are listening to. We’ll help steer you back on the path again if you find yourself beginning to wander.

* Think institutions do have emotions? Try telling your bank, phone or credit card company that you mailed your payment well ahead of the due date. It arrived a day late because the 16” snow storm kept the postal carrier from delivering mail. If you’ve got any chance at getting the late charge waived, it’s only because you found a sympathetic person somewhere within that organization. And we both know the odds of that happening at (insert your choice here)! Again I’ll say, no, institutions are not smarter. That lack of emotion just makes them colder.

Source:
2 reasons why investors miss stock rallies. James Liu. about.jpmorganfunds.com. October 30, 2014.

The data above were taken from sources deemed reliable. However no guarantee can be made as to their completeness and accuracy.
Interpretations of the data, views and/or opinions expressed are those of the Jamison Financial Group based on market and economic conditions as of the date of publication and are subject to change. They do not necessarily reflect the opinions of any other individual, group or organization.
Nothing in the above is meant to be, nor should it be construed as, investment advice or recommendations to buy or sell any security. Individual securities whenever mentioned are for illustrative purposes only and may not be relied upon as investment advice.
Tax and/or legal information contained herein is general in nature and for informational purposes only. It should not be relied upon as advice. Consult your tax professional or attorney regarding your unique situation.
All indices are unmanaged and are not illustrative of any particular investment. A direct investment cannot be made in any index.
The Dow Jones Industrial Average is a price-weighted index of 30 actively traded blue-chip stocks.
The NASDAQ Composite is a market-weighted index of all the over-the-counter common stocks traded on the NASDAQ system.
The S&P 500® is a market-capitalization-weighted index of common stocks.
Past performance is no guarantee of future results.

© 2014 Jamison Financial Group. Please feel free to distribute copies to individuals you feel may benefit from the information presented. Commercial use is prohibited.