Irrationality and investing

The Morningstar article reprinted below on Investor Irrationality is worth reviewing in these challenging times

The article makes the case for asset allocation, with a long-term view, and to holding on and not attempting to time the market.

Implicitly, the article makes the case for having a good advisor work with you to avoid falling into these traps of irrational investing. We hope are guidance has worked!

Thanks,

Steven


In Practice: Patterns of Investor Irrationality

by Jim Licato and Alina Tarlea | 10-15-09

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Here are some common ways issues of behavioral finance show up in practice.

The Melting Pot

Despite the recent run-up in the stock market, it is safe to assume that investors are still a bit hesitant to get back into the market (or to stay in the market), let alone consider the riskiest of investments. What investors should understand is that separate types of investments perform differently from one another, which has made it possible to lower the risk of volatile assets by combining them with other types of investments.

Allocation Return Risk

Large Stocks 20% 9.4 17.3

Small Stocks 20% 11.7 25.1

Bonds 20% 8.8 11.8

Cash 20% 5.8 0.9

International Stocks 20% 9.8 19.1

Total Portfolio 9.8 11.0

Mental accounting is a pattern of investor irrationality in which an investor mentally compartmentalizes investments while neglecting to focus on the portfolio as a whole. Mental accounting can often impede investors from making sound financial decisions.

This investor behavior is often evident when international investments are introduced. Risks that often raise red flags when investing internationally include currency, economic, political, and market liquidity. When clients view this particular investment in a vacuum, they are usually less receptive to include it in their portfolios. They are dismissing the potential diversification benefits of international investments and possible improvements in the risk/return trade-off.

While the relative safety of cash and bonds may be soothing, especially during this day and age, investors are sacrificing long-term growth. Some investors may be willing to sidestep greater returns because the volatility of stocks may be too intimidating. As shown in the table, by focusing on the whole portfolio (and not just the individual components), an investor would actually experience a risk level that was lower than bonds and a return that was comparable to stocks.

It is important to note that some mental accounting may be helpful for your clients. For example, if it is helpful for them to mentally account for investments in terms of the goals they are trying to achieve (retirement, college savings, etc.), mental accounting could be warranted. In most cases, however, where your clients are reluctant to get back into the market, or to just stay the course, having them concentrate solely on the total portfolio may help pacify them.

Short-Term Focus

It’s tempting for clients regularly to monitor their investment accounts. Instant access to real-time quotes and a barrage of media reports on daily stock market fluctuations can make it difficult for clients with a long-term investment horizon to stay focused on their goals. In reality, these daily market movements may not be as extreme as they seem. As investors look longer term, their perception often changes. (1989-2008 probability of losing money in the market: daily 46%, monthly 37%, quarterly 30% and annually 25%)

Short-term market fluctuations can be quite volatile, and the probability of realizing a loss within any given day is high. However, the likelihood of realizing a loss has historically decreased over longer holding periods. The [parenthetical above] illustrates that while the probability of losing money on a daily basis over the past 20 years was 46%, the probability dropped dramatically to 25% when analyzing an annual time period.

Periodic review of an investment portfolio is necessary, but investors shouldn’t let short-term swings affect their view of the future.

Investor Returns

Time and time again, financial experts have recommended a long-term approach to investing and have cautioned investors against market-timing attempts. Despite these warnings, a typical trait of investor behavior is overconfidence. People exhibiting this behavior believe they have the ability to identify market highs and lows, and they invest based on this belief.

It is extremely difficult, however, to consistently time the market, which is why overconfidence can lead to disappointing results. (related graph available on request) Contrary to their desired strategy, many investors end up buying high and selling low, which drastically diminishes their returns.

Morningstar Investor Returns measure how a typical investor performed over time, incorporating the impact of cash inflows and outflows from purchases and sales, as opposed to total returns, which assume investors held the investment for the entire time period. The graph compares average investor returns for stock and bond funds to the returns of stock and bond benchmarks. For all but two time periods analyzed, investor returns have been consistently lower than market returns.

Regret and Risk

Investors often react emotionally after realizing an error in judgment has been made. Investors prone to regret may base investment decisions on regretful decisions they made in the past, encouraging them to become either risk averse or to take greater risks.

Consider the situation of each of the following investors. Client A purchased shares in Company ABC on Jan. 1, 2007. He sold the shares at the end of June 2007 because the stock’s performance was flat. Client B considered purchasing shares in Company ABC on the same day Client A sold his shares, but she decided to take a pass. Company ABC went on to triple in price from July 2007 through July 2009. Which investor is unhappier as a result of his or her decision? The outcome is the same; both investors should have the same amount of regret. However, studies show that the regret of having done something is greater than the regret of not having done anything. Therefore, Client A has more regret than Client B.

There’s another layer to regret. Daniel Kahneman and Richard Thaler asked 100 wealthy investors to bring to mind the financial decision they regretted most. Most participants reported that their greatest regret was from something that they had done. Those who reported a regret of not having done something were shown to take on more risk; they held an unusually high proportion of their portfolio in stocks.

Jim Licato is Morningstar’s research and communications manager. Alina Tarlea is a Morningstar research and communications analyst.

Let us know if you have questions or comments. Thanks,

Steven