Trust your instincts. Except in investing. How human nature can derail investment results.

Posted Friday, May 14th, 2010 at 3:01 am

In most aspects of everyday life, instinct serves us well. It protects us from danger. It attracts us to exciting business opportunities, and helps us recognize those that are too good to be true. It draws us to the key characters in our lives – friends, spouses, collaborators, mentors.

Instinct is a magical compass, pointing us toward opportunity and away from peril. When we betray our instincts, we often pay a price. So it is only natural that many investors follow their instincts as they make investment and wealth planning decisions.

Unfortunately, instinct may be highly fallible – even dangerous – when it comes to investing. It may lead us to poor choices as we select investments, allocate assets, pick advisors, evaluate advice, and decide when to buy and sell.

Here are a few ways that human nature can lead us down the wrong path:

Bet on proven winners. We spend our whole lives trying to be the best and find the best – the ideal house, the winning team, the right neighborhood, the perfect wine, the best college. We do the research, crunch the numbers, dissect the trends. We look for patterns of performance that demonstrate accomplishment, reliability, and potential.
We pride ourselves in being able to see what’s what. There is satisfaction in buying an Acura, knowing it will delight us on the road and hold its value too. When we take the same approach to investing, however, we are treading in precarious territory.
Selecting a stock, mutual fund, or money manager based on past performance can be an invitation to disappointment. It turns out that the familiar disclaimer is right on – past performance is no guarantee of future results. It’s no guarantee, and not even a very good general guide. Princeton economist Burton Malkiel eloquently presents this principle in his influential book, A Random Walk Down Wall Street, now nearing its thirtieth edition.
This concept can be tough to accept. It seems self-evident that a solid company with growing profits and a rising stock price is likely to outperform a no-growth laggard. But the market is smart. The good prospects of the growing company are quicklypriced into its stock. Thus, investors must pay a premium for the “better” stock, eliminating any seeming advantage. This is the Efficient Market Hypothesis in a nutshell, one of the most important notions in investing, and a direct affront to instinct.

Ditch the losers. This is the flipside of betting on winners, and perhaps even harder to swallow. Human nature tells us to learn from our mistakes and punt away our poorly performing investments. Market efficiency, however, tells us that the weakness of a laggard is discounted into its price, and therefore, a recent loser is no more likely to fall in price in the future than a recent winner.

As Malkiel describes, trying to pick tomorrow’s winners based on what happened yesterday, last week, or last year is no more reliable than choosing securities at random.

Never settle for second place. Both nature and nurture drive us to be the best. If there is any chance to be #1, we go for it. The thrill of victory is our aim, and our right.

In investing, this instinct to outperform can drive all sorts of bad decisions – accepting unwarranted levels of risk, jumping from horse to horse, ignoring costs and taxes in pursuit of short-term gains, overpaying for the guidance of so-called experts, chasing fads, and trading on rumors, among others.

A 99th-percentile-or-bust mentality is more likely to deliver the latter, not only because it is so difficult to outsmart an efficient market, but because of the high levels of expenses inherent in any investment strategy that involves frequent buying and selling.

Forget the 99th percentile; even the goal of finishing in the middle can be derailed by instinct. According to a study from Dalbar, Inc., the S&P 500 returned an 11.9% annualized return from 1985 to 2004, but the average investor in mutual funds earned just 3.7% annually, barely more than inflation. This severe underperformance likely results from investors rushing into hot funds near their peaks and giving up on faltering funds as they approached lows. No one would intentionally buy high and sell low, but instinct makes it easy to do.

Be different. In an attempt to outperform, instinct may tell us to invest outside the box, to go where lesser investors are too timid or unsophisticated to venture. This can result in a portfolio packed with risky, illiquid, and difficult to understand positions. Many specialized investment vehicles (such as “2 + 20” hedge funds), playing on their exclusivity, exact heavy sales loads (a 2 percent, or higher, upfront fee) and direct a significant share of returns (20 percent of profits) back to the manager. These built-in disadvantages make outperformance for the individual investor that much less likely.

When in doubt, trust the names you know. In the best of times, investing can be somewhat confusing, even for experienced investors. In falling markets it can be downright scary. In response, our survival instinct may lead us toward havens of familiarity. When in doubt, investors may be drawn to the best-known financial names – major Wall Street brokerages, brand name mutual fund families, and iconic analyst firms and rating organizations.

It is natural to find comfort in the names we know, but blind faith is never justified. In many cases, name recognition is driven by the size of advertising budgets, not necessarily the quality of investments offered or guidance delivered. In fact, the high overhead inherent in the largest, most heavily marketed organizations can be a direct drain on the results ultimately realized by investors.

With financial well-being hanging in the balance, no firm or advisor should be considered above the need for rigorous due diligence. Investors need to know what they are paying for, and what they will receive. For instance, the major brokerage firms may pledge to protect the interests of their clients, but because they are not bound by a legal fiduciary duty (as registered investment advisors are), they are free to act in ways that serve their own interests at the expense of clients.

Let’s be clear. The big brand names can deliver excellent service and good investment results. But size and familiarity are not, in themselves, a basis for trust. Every vendor, agent, or advisor deserves scrutiny. After all, it’s not their money at stake.

If not instinct, then what?

It’s clear that following our instincts can betray us as we invest toward long-term financial goals. But what is the alternative? How can we overcome our instincts to make better decisions?

The easiest answer is to make fewer decisions. For starters:

  • Invest not in individually selected stocks, but in asset classes – groups of securities that have similar characteristics and move largely as a group. For instance, large capitalization US stocks.
  • Build a diverse portfolio that represents the breadth and depth of the market. Own a mix of distinct asset classes: domestic and international securities, large and small, growth and value.
  • Buy and hold for the long term, with the goal of consistently earning market level returns.
  • Minimize transactions that can drive up expenses and tax liabilities.
  • Rebalance as needed and make adjustments when goals or personal circumstances change. Otherwise, leave it be.

Ignore the temptation to try to beat the market. That means not trying to pick wining stocks based on past performance, earnings or anything else – and not quickly selling when a holding loses momentum. It means avoiding alternative investments, such as hedge funds and derivatives, no matter how appealingly exotic or exclusive they may seem. It means working with a financial advisor who can implement these ideas and act as a rational buffer against the urges of instinct that will inevitably arise. And it means choosing an advisor based on careful due diligence, not on blind trust of familiar brand names.

Instinct is a powerful and mysterious force. Enjoy all that adds to life, but not when it comes to investing.

This article is provided on behalf of The BrightSky Group, of which we are a founding member

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