Are investors irrational?

by Jerry Wagner

The efficient market hypothesis asserts that the markets are made up of rational investors and, thus, are so efficient that market pricing cannot be exploited for a profit.

This is the foundation on which passive asset allocation is based. Yet, the theory took a blow in 2002 when the Nobel Memorial Prize in Economic Sciences was awarded to someone whose work demonstrated that investors do not always behave rationally.

In a series of studies, the late psychologist Daniel Kahneman, in collaboration with the late Amos Tversky, showed that most of us humans are incapable of fully analyzing complex situations when the future consequences are uncertain. Faced with uncertainty, investors exploit rules of thumb that systematically contradict basic logic—or, as an overview of Kahneman’s work published by the Nobel Prize explains, rules of thumb that “systematically contradict fundamental propositions in probability theory.”

Unfortunately, I have seen many examples of these investor mistakes in the more than four decades since I started Flexible Plan Investments. If the following phrases sound familiar, be careful.

“I’ll sell when I get back to breakeven.”

Often called the “loser’s lament,” this frequently repeated statement by “buy-and-hope” investors in a declining market can encourage them to keep holding on.

It can also be the undoing of actively managed accounts in a turnaround market. Many actively managed strategies seek to make money by taking advantage of the persistence of upside momentum. A return to breakeven on an actively managed account may be a vindication of the strategy and could be one of the best times to hold on. Selling then could cause an investor to miss out on future market gains.

“I’ve lost $X or X% since the market top.”

Investors often want to measure their performance from the stock market’s high-water mark. This is not realistic. I’ve yet to find a single professional or investor who has been able to consistently sell at the top. Instead, investors often buy near market tops rather than sell at them.

An evaluation of a portfolio should include both an up and a down market. Ask yourself, “How have I done since I started?” Did you open your account at a market top, like many investors? Have you been invested long enough to have experienced both an advance and a decline?

“I didn’t invest to lose money.”

No one invests to lose money. Yet, investments that have historically outperformed inflation over the long run generally involve some risk of loss.

Most often, investing is like an exercise program: “No pain, no gain.” The skill comes in minimizing the pain when a market correction comes along so that the portfolio remains positioned to participate when conditions improve.

“If I’m down for the quarter, I’m selling” or “I want the strategy that did best last quarter.”

Both statements fail for the same reason: The period for evaluating the investment is too short to be meaningful.

A meaningful measurement period should encompass both an advancing and a declining period in the stock market. Historically, that has often required an investment time of five to seven years, though the length of a complete market cycle can vary.

“How did my investment do versus the S&P?”

The S&P 500 Index can be an appropriate benchmark for an investment focused on U.S. large-cap stocks. But few investment professionals would recommend that an investor place all of their assets into a fund that mirrors the S&P 500. Instead, they generally tell investors to diversify.

Actively managed investors should compare the results of their entire portfolio against a benchmark that reflects its investment mix, objectives, and level of risk to get a more realistic measure of relative performance. Our OnTarget Investing reports, included with your quarterly statements, show how you are doing versus a benchmark customized for your account.

“The market was up last quarter. The good times are back.” or “The market was down last quarter. The worst is yet to come.”  

Investors should be careful about drawing broad conclusions from short-term market moves. One quarter does not necessarily establish a lasting trend. Investors should take a broader view.

“What’s the difference between active and passive management?”

Imagine that you are taking a long trip. You will be gone for six months. If you can speak to a weather forecaster only once before you leave, the forecaster would have to tell you to be prepared for everything. Since you don’t know what climate changes you will experience over the next half year, you’ll need sunscreen, winter boots, a raincoat, a windbreaker, and so on.

However, if you could speak to the weather forecaster every week, you would need to be prepared only for the current weather conditions.

A passive manager generally maintains a predetermined mix of investments in the portfolio, much like packing for every possible kind of weather. The portfolio may hold several asset classes because no one knows in advance which one will perform best. This approach may reduce certain risks, but it also may limit participation in the strongest-performing areas.

An active manager, on the other hand, can adjust the portfolio as market conditions change—more like checking the forecast and changing what you pack. Flexible Plan Investments seeks to increase exposure to stronger-performing asset classes and reduce exposure to weaker performers.

Of course, the weather forecaster isn’t always right—and neither is the active manager. But we think you will agree that adapting to the climate makes more sense than carrying everything in your closet every time you leave for a trip.