Its all about being diversified across asset classes and rebalancing
Much has been written in the last five to 10 years in the field of behavioral finance about how humans make financial decisions. It seems our species isn’t wired particularly well for making smart decisions around money, especially during a crisis.
As best-selling author, Daniel Kahneman writes in his dutifully researched, Thinking Fast & Slow, sometimes our brains operate as an automatic system (thinking fast), and sometimes as a reflective system (thinking slow). We would all like to behave as rational creatures, making astute financial decisions based on facts and independent reasoning, but confronted with a severe market meltdown, our automatic response is to sell.
Reptilian responses to stress universal
How many of us at the beginning of the 2008 financial storm held firm with our stock or mutual fund positions, or at the bottom of the financial crisis in March of 2009, actually bought into that dreadful downward spiral? How will we react in the next financial crisis? A lizard or any reptilian brain will react instantly to pending danger; it doesn’t have a calm internal discussion of the pros and cons of the right course of action. Humans react with the same knee-jerk responses to other kinds of emotional stress as well.
Five years into the market recovery, we often hear pundits or advisers say in hindsight how easy it has been to make money. Easy? Are we fooling ourselves? Looking back at March of 2009, it surely wasn’t easy. How many individuals during any financial crisis are committed, disciplined strategic players, diversified into many asset classes and willing to keep their portfolios balanced at all times?
Reflecting back, I’ve attended many conferences and read much in the professional investment journals and magazines about the demise of the strategic asset allocation portfolio -the philosophy that recommends setting target allocations for various asset classes with periodic rebalancing – as dead in the water. I’ve even seen advisers resurrect “tactical asset allocation,” attempting to outsmart the market in a vain search for mispriced assets. I’ve watched an army of Wall Street “wizards” steer advisers and the public into new alternative investments with little evidence of much return since 2008. In short, I’ve witnessed many professional investment advisers behave no better than the average investor, or as Morningstar’s John Rekenthaler puts it, “The big money looks a whole lot like the small money.”
No one out-smarts or out-times the market
Our brains are wired to instantaneously detect patterns. People, advisers included, think they can make sense out of what is really random. Why has the average investor’s stock investments, as reported in the Dalbar Study from the period 1991-2013, gained only half as much as the return on the S&P 500 index, or 5.02 percent versus 10.03 percent? It isn’t necessarily because they pick lousy mutual funds or stocks, it’s because they’ve made poor timing decisions. They sold, when they should have bought, and they bought when they should have sold – they’ve reacted hastily and paid the price. Those illusionary patterns or those bad recommendations, from financial media and pundits on the internet, simply steered the investor in the wrong direction.
One important realization an investor can make is to recognize we don’t understand the world very well; otherwise we would do a lot better in predicting what happens.
The good news is, we actually don’t have to predict where the markets are going, or react instantly to bad financial news; we merely need to build a well-structured portfolio diversified amongst a broad range of different asset classes and rebalance periodically.
And if we can’t keep the lizard brain under wraps, maybe we need to hire a rational head to handle our finance. Just don’t hire a lizard, the one that thinks he/she can outsmart the market!