When Your Brain is Your Enemy

Gary Alt |

Question: Last week I finally succumbed to my fears of the market and moved all my 401K investments to a money market fund.  It may have been an overreaction to all the hype on the news about the Greek debt crisis, but as I get older and closer to retirement I get more afraid of losing my money.  Now I’m stuck because the money market fund is paying next to nothing and interest rates on safe investments are barely keeping up with inflation.  I have no idea where this money should be. What should I do?

Answer: Welcome to the crowd.  It may not be of any comfort for you to know this, but you are behaving like a typical investor.  Dalbar, a Boston research firm, issues its “Quantitative Analysis of Investor Behavior (QAIB)” study every year, and every year the results are the same.  The study shows that over the most recent 20-year period, the rate of return of the average investor in U.S. Stocks was only about half the rate of return of the U.S. stock market (as measured by the S&P 500 index). The study further concludes that a major reason for this underperformance is psychological.  Instead of staying invested, do-it-yourself investors tend to get in and out of the market at the wrong times.  Dalbar has narrowed down this irrational investor behavior to nine biases.  They are:

Loss Aversion: This bias results in panic selling, when the fear of loss leads to “selling low.” 

Narrow Framing: Investors sometimes will change a part of their portfolio without considering the consequences that the change will have on their overall portfolio.

Anchoring: Investors sometimes only focus on past performance of an investment and will “anchor” to this performance and assume it will continue.

Mental Accounting: Investors sometimes tend to look at investment performance of each investment separately, rather than the performance of their overall portfolio.

Lack of Diversification: This is an all-to-common investor mistake.  Contrary to what some investors think, a few stocks or even a few mutual funds that invest in similar stocks do not diversify a portfolio. 

Herding: Think of lemmings, mass suicide, and jumping off cliffs.  Investors may not be so drastic, but doing what everybody else is doing can result in always “buying high and selling low,” which can be deadly to your financial life over time.

Regret: Okay, you made a mistake.  Don’t let that keep you from making the necessary portfolio decision the next time. 

Media Response: You are probably well aware that you won’t see magazine covers or hear TV talking heads espouse pessimism.  That’s because their advertisers pay their salaries, and their advertisers want you to buy their products.

Optimism: Don’t make overly optimistic assumptions about what investments to buy.  Be rational.  

What should you do?  Study investment history and economic theory.  You will learn to: (1) Always expect the unexpected; (2) Realize that nobody can consistently and correctly predict future economic events, market performance, or interest rate movements; (3) Accept that it is difficult, if not impossible, to consistently select only superior stocks; (4) Know that it is impossible to “time” the stock market; (5) Build a diversified portfolio; and (6) Gather the wisdom and fortitude to persevere.

Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment advisor and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning.  Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA  93940 or email them to ken@montereypw.com.