INVESTOR ILLUSIONS

Everyone knows that a crystal is used to look into the future.  Most of us realize, however, that you can’t make important life decisions based on an image foretold by a crystal ball.  There are three commonly espoused methods of investing that can be paralleled with gazing into a crystal ball.

Stock Picking – Finding company or industry stocks that are “under-priced” with the notion that they will provide superior returns in the future unrelated to risk.

Market Timing – Attempting to alter the mix of assets in a portfolio based on a prediction about the future direction of the market.

Track Record Investing – Assuming that the past performance of a specific provides pertinent information regarding its future performance.

Investors continue to believe that if they look long enough, hard enough and in the “right” places, they will discover a way to get massive returns on their investments without taking any real risk.  Deep in the psyche of the investing community at large is an assumption that there is a method whereby investors should be able to experience all of the gain with none of the pain.  This is what we call a “free lunch”.

Unrealistic expectations are indisputably one of the most common reasons that investors experience disappointment, anxiety and frustration about investing.  However, for the most part, these expectations may never be verbalized.  While an investor will react to the results of his portfolio based on an underlying expectation, he may never consciously recognize the expectation for what it is.  Therefore, it is helpful to gain greater awareness by exploring six reality breakdowns that typically cause investors to make poor investment decisions:

Hindsight Bias – Monday Morning Quarterbacks.  Knowing the outcome of some event makes it easy to delude ourselves that we, in fact, could have predicted the outcome with certainty, before the fact.  You can see hindsight bias at play whenever you hear someone say “I knew that was going to happen”.  It is a common place tendency, and we’ve all done it.  However, the fact of the matter is that none of us can predict actual outcomes in the future with any level of confidence.  Hindsight bias focuses on past events and lulls us into believing we had it all figured out.  The phenomenon of hindsight bias is dangerous in investing because it sets up unrealistic expectations for the future.

False Patterning - Shooting Streaks.  Just as sports fanatics can get caught up in an athlete’s apparent “hot streak’, investors are easily convinced that the market (or a certain investment in the market) is going to follow a particular pattern.  This tendency is potentially harmful in investing because it leads to a mistaken sense of certainty about what is going to occur in the future.  The simple fact that investment magazines continually publish and report on mutual funds’ performance is based on the illusion that past performance is related to future performance.  As documented by the esteemed economist Burton Malkiel, professor at Princeton University and author of  “A Random Walk Down Wall Street’, and as can be read in the fine print of most mutual  fund prospectuses or investment literature: “Past performance does not indicate, and is not a guarantee of future performance”.

Emotion-Based Decisions – Most of like to believe that we use logic when making important decisions in life.  We are taught to value reason, common sense, and sound judgment.  But, we are only human and inevitably emotions will creep into our decision-making process.  Using emotions in our decisions is not bad, in fact it can be very beneficial as long as we don’t use our emotions to distort the factual data.  When emotions drive the decision-making process, we invariably overweight the data that supports our emotions (or gut feeling) while simultaneously underweighting data that contradicts those feelings.

Investment Pornography – Investment information designed to appeal to investors’ obsessive speculation tendencies.  In the quest for peace of mind about investing, most of us turn to various sources of so-called expert information.  The most common places to seek understanding and enlightenment are the popular media: magazines, newspapers, books, TV, radio, and the internet.  These messages tend to be based on hype, rhetoric and manipulation.  Instead of offering knowledge and clarity, they often provide conflicting advice, useless propaganda and confusing analyses.  The financial media is often specifically geared to activate and intensify the instinctual urges which drive emotional decisions by the investor.  Think of it as “investment pornography.  Investment pornography is designed to sell newspapers, magazines, books and investment products.  Investors need to be cautious about believing what they read lest they wind up with a poorly constructed investment portfolio and very little peace of mind. 

Overconfidence – An undeserved sense of certainty, ability, or skill.  Just as we are likely to think we are “above average” drivers, we are equally prone to overrate our own ability to beat the market.  The research study by Dalbar helps explain why most investors will never beat the market.  Dalbar, Inc. is a leading independent financial services research firm that has conducted numerous studies concerning investor behavior.  Their most significant finding is that regardless of how well any particular investment may perform, the average investor is unlikely to realize the same return.  For example, while the S&P 500 earned 11.00% from 1984 to 2005, the average equity fund investor realized an annualized return of 4.12%.  One contributing cause for this result is that the average investor’s holding period for a fund was only 2.9 years.  Investors were chasing market returns selling when a fund dropped in value (selling at the low) and buying when funds were on the way up (buying at the high). Therefore, they missed the long-term gains inherent in the fund.  We all recognize the first principle of investing is to “buy low and sell high”, unfortunately this study indicates the opposite is more commonly true for the average investor.  In the end, the crucial point to remember is that an investor’s performance does not equal the investment’s performance.  Chances are you will under-perform the market, not beat it.

Necessary Lie Syndrome – Justification applied to imprudent behavior.  Necessary lies are the seemingly harmless little things we tell ourselves when we’re doing something we know we shouldn’t do.  Inherently, we can sense when we are involved in behavior that could be considered reckless or irresponsible.  After years of conditioning, there is often an internal voice whispering that we are breaking the rules.  Natural responses to this kind of self-condemnation are rationalization and justification.  Even if we are only talking to ourselves, we are hardwired to excuse and defend our own behavior.  This tendency only becomes more pronounced in situations in which we feel someone else might be judging our behavior.  These are the times when we generously apply necessary lies.  These seemingly minor falsehoods let us off the hook for doing what we know we shouldn’t.  The remedy to necessary lies is brutal honesty.  If you are ever going to be a realistic investor, then you must be willing to admit your own falsehoods.  Think about your own investing situation.  How have you been fooling yourself?

The principles we utilize in structuring our investment portfolios are based on sound academic research and Nobel Prize winning investment allocations utilizing true asset class diversified funds which are re-balanced not less than annually.  The result is a long-term investment plan which facilitates, by design, selling those asset classes which have performed well (selling at the high) and buying those asset classes which have performed poorly (buying at the low).  Additionally we customize the investment asset class allocation for each of our clients based on their individual tolerance for risk and financial time horizon.  Don’t be disillusioned.  You can’t blindly entrust your financial future to anyone, it’s your responsibility.  Contact our office to learn more about our proprietary, scientific, Nobel Prize winning investment allocation to reduce decision making, stress, anxiety and enhance attainment of your financial goals.