January 2010 - Personal Planning: Investor Psychology

We were fortunate to be joined by Professor Meir Statman of Santa Clara University at our Financial Forum in January. Prof. Statman is an internationally-recognized expert on the subject of Behavioral Finance, and his presentation established the framework for a lively discussion on a subject that we have long felt plays an important and ongoing role in long-term investment success. As Prof. Statman explained, we behave as we do in large part because we are affected by our emotions, and the impact of our emotions is not limited only to periods of financial “bubbles.” One rather profound example of this is a Dalbar study showing that during one of the greatest bull markets of all time from 1984 to 2000, the S&P 500 returned over 12% annually; and yet, the average equity mutual fund investor received only about 3% annually. This is really quite astonishing, and frankly hard to believe. Simply put, the majority of investors bought and sold at the wrong times, and thus significantly limited their returns. They bought along with the crowd when prices got too high (and seemed unlikely to ever fall—maybe even due to a “new paradigm”) and then sold—again, right along with the crowd—when prices got too low (and seemed unlikely to ever recover).

One can only point to emotional decision-making to reconcile this dramatic performance difference, and emotional decisions are almost always bad decisions. Even investors who do not react right along with the madness of crowds can do much harm to their long-term success if they make emotional decisions. For example, selling everything in late 2008 (presumably at a loss) might have seemed like the right thing to do by March 2009; but then very few of those same investors would have had the stomach to step back in (which in retrospect would have been the “right” time to do so) just as things got even worse than they had initially feared. Then, as markets recover, the very difficult task arises of timing a re-entry; and as the markets climb, the conviction that prices are moving up too much and too quickly causes most people to hold off—and this becomes a vicious cycle.

The bottom line: Courage is very difficult to muster just when it is needed most. It is much better to establish a plan based on personal needs, objectives, and risk considerations and commit to it, understanding that the discipline it takes to stick with that plan will inevitably be tested along the way. This reasoning is underscored by what Prof. Statman calls the first lesson of investing — “Know Yourself,” and Sand Hill spends a great deal of time working with its clients in this area.

And yet, it is worthwhile to ask why we even bother to take investment risk in the first place. We need to recognize that there are actually many different kinds of risk to consider when investing, and that there are trade-offs we must make in dealing with these differences. Volatility is the most obvious risk (at least on the downside), and it is measured by market or price risk, which gets all the media attention and headlines. Equity investments, like common stocks, are usually quite volatile, especially during short time periods. Inflation, however, is another important consideration and concern—and it is measured by purchasing power risk as well as “longevity” risk. Interest-generating investments, like cash and bonds, are usually the least volatile kinds of investments, but they are also the most susceptible to the adverse effects of inflation. Even modest inflation is a major risk, and a 3% inflation rate—the long-term average—cuts purchasing power in half in just about 25 years. Moreover, many “big ticket” expenses (like education, health care, and housing) have typically grown at much faster rates than the average rate of inflation. Because of these risk trade-offs, we are extremely thorough with our clients’ overall risk assessment, and work to determine both their tolerance for risk and their need to undertake risk to achieve their goals. This involves the use of appropriate cash flow analysis that tests both short-term and long-term expected downside risk. We will expand our views of this subject in the next issue, and also explain the other behavioral lessons that Prof. Statman shared with us.