The well-studied principles of investor behavior are a large part of what moves our markets both up and down.  Investing strictly on facts and discipline is difficult - after all, we are humans processing information with all the emotions, biases and shortcuts that get in the way.

Herd Mentality, Loss Aversion, Fear of Regret - these are the names given to just some of the various behaviors that cause people, as emotional beings, to make mistakes in their investment choices again and again.

One such behavior called “Overconfidence” occurs where investors make errors in overestimating the accuracy of their opinions and information, often due to past investing ‘successes’.

As a whole, overconfident investors trade too much. In a study I recently read, 78,000 households were divided into five groups based on trading frequency. The average portfolio return for the highest trading frequency group was almost 40% less than that of the lowest trading frequency. Along with trading frequently, overconfidence often leads to purchasing the wrong investments.

In another study, the same researchers followed brokerage accounts that sold a stock and bought a replacement stock shortly after. In the four months following the trade, the stocks that were sold on average earned 2.6% vs. only 0.11% earned by the replacement stocks. After a year, the stocks that had been sold outperformed the replacement stocks by 5.8%.

Of course this data, while reliable in it’s own context, does not necessarily apply to today’s market conditions.  However, the behavioral finance theory certainly does.

It is very important to truly understand why you are selling or buying a certain stock.  If it is for technical analysis reasons, understand the risk-reward scenario and the charting pattern your are following.  If it is for fundamental reasons, understand the company and what drives revenues and expenses.  Don’t listen to the talking heads in the media - they make money spreading bad news and driving down investor confidence - also known as emotion.

As hard as it is, emotion is best left at the door when dealing with your investment portfolio.

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If you have heard it once, you have heard it one thousand times. This age-old advice is the epitome of the saying “it’s easier said than done”.

In recent months, my favorite sector, the financial sector has taken a beating. Many of my favorite stocks are now boasting dividends in the mid to high single digits. These dividend yields are quite a bit higher than the average yields for these companies, not to mention that some of the largest banks in the gargantuan US economy are selling at 10-12 times earnings!

Enter Investor Psychology

Even though I have a long-term investment strategy and believe in the future prospects of companies such as Citigroup (C) and Bank of America (BAC), I still have a hard time pulling the trigger when all of the news outlets are forecasting nothing but doom and gloom.

Money is made when one is brave enough to accept a risk that few others are willing to take. We must be willing to step out on a limb and believe in our strategy from time to time, for there is no reward without risk!

Brave or Stupid…You Decide

A recent article in the Globe and Mail outlined the following, which I thought was a spectacular move, and outlines some of my own thoughts:

Bill Miller, the famed mutual fund manager at Legg Mason, might describe as predictable, but illogical, market psychology.

Studies repeatedly show investors place too much weight on information that’s (a) recent, and (b) dramatic. The multibillion mortgage writedowns at U.S. banks are both.

Mr. Miller, who beat the Standard & Poor’s 500 for an incredible 15 consecutive years, has been getting enthusiastic lately about U.S. financial stocks. At the moment, he looks foolish and stupid. Two years from now, he’ll be thought of as brave and wise.

What Mr. Miller is referencing is a common strategy known as contrarian. Being a contrarian is just as it sounds. Contrarian investors buy solid stocks that have fallen out of favor with investors, mainly due to recent news and “panic“.

Buffettology

Mr. Warren Buffett actually played a contrarian role the last time that the financial sector was out of favor in the early 1990’s. Buffett took a large stake in Wells Fargo when everyone else was running far and fast from the financials. If you take a look at a 15 - year chart for Wells Fargo, you’ll see that Buffett looks Brave and Wise now, not Foolish and Stupid!

Buffett also made recent headlines for his investments in Goldman Sachs and General Electric, not to mention a NY Times article in which he proclaimed that his personal portfolio is currently being invested in United States equities.

Are you prepared to look foolish and stupid for a few months in order to look as brave and wise as Warren Buffet in the future?

If so, you too could be taking double digit dividends (and capital gains) to the bank 10 years from now!

According to the Globe and Mail, panic sticken investors in Canada pulled a record $8.45-billion from the mutual fund market in a stampede for the exits. It was the worst month for net outflows since the Investment Funds Institute of Canada (IFIC) began collecting data in 1990, and nearly doubled the previous record posted in September, which saw net outflows of $4.5-billion.

Panic Selling

Of course many will be inclined to argue that those who pulled thier funds from the market in early October were smart and can now re-invest at lower prices.  While this is true, the figures shown are net outflows for the month - so we’re not talking about trading or churning of these funds.  This data is a decent representation of those investors who panic-sold.

Further to this point, most seasoned traders, who would be more inclined to recognize the market conditions and sell their holding to re-invest at a later date are likely not invested in mutual funds, but rather individual securities.

One such example of an individual who panic-sold is Norman Bambrick, a 72-year-old retiree in Port Perry, Ont. He bailed out of his bank fund after seeing his $200,000 investment in two accounts take a $12,000 haircut in 10 months.

“The funds didn’t work out for me and I cashed them,” Mr. Bambrick said.

“I had a feeling that they were headed for a disaster,” he said. “I had no confidence in them.”

What is even worse about this example is that the gentleman suffered just a 6% loss to his portfolio.  This is an indication that he has received some incorrect advice about his risk tolerance and the investments that he holds.

Understand Your Risk Tolerance

If Mr. Bambick could not tolerate a 6% loss to his portfolio, he should not have been invested in those vehicles.  At 72 years old, with such a low risk tolerance and relying on his portfolio for income,  Mr. Bambick should likely be invested in Guaranteed Investment Certificates (CD’s in the USA) and Fixed Income securities only. Fortunately, that is exactly what Mr. Bambick did with the proceeds from the sale of his funds.

While this example is of an investor who was not likely in the appropriate asset allocation for his situation, it is still an example of panic selling.  When we sell out of fear instead of understanding our fundamental reason for selling we often lock in losses.  And, by the time we get up enough “courage” to return to following our original investment plan (when general market sentiment turns positive), we have often missed out on the initial upside gain.

The moral of the story is this:

• If you were lucky/smart enough to cash out before the downturn - don’t be too late to re-invest those proceeds because prices are much more attractive now.
• If you panic-sold during the downturn get prepared and develop a plan that is comfortable for you.  Don’t miss out on potential gains when the market turns the corner.
• If you have been holding throughout, stick with your plan because this time is not different and equities will rebound as market uncertainty eases and we return to the fundamental valuations.

I personally fall into category number three and have been buying dividend growing stocks and some index ETF’s over the past 5 weeks. 

Which category are you in?

Historically speaking, the volatility we’ve witnessed has not been normal. And after almost five years of below-average volatility levels, the past few weeks have felt even worse. Recently a closer look at volatility in U.S. equity markets was studied within a historical context.

Market Volatility Over The Century

The statisticians went as far back as 1900 to gather points of data on all instances when volatility significantly deviated from the historical long-term average (for you statistics gurus, that’s +/- 1 standard deviation from the norm). I’ll continue to refer to this anomaly as a “surge in volatility”.

As observed in the chart below, it is evidenced that aside from the past few weeks there have been four specific instances in history when we have seen an extreme surge in volatility - October 1929, February 1938, October 1974 and October 1987 (notice the frequency that the month of October occurs).

Based on a comparison of these historical periods, here are some observations:

•  The increase in volatility occurs very quickly.
•  In three out of four times, the market bottomed within one month after the initial surge in volatility (in ‘74, the market bottomed two months after the initial surge).
•  In all but one period, the stock market was up in the 12 and 24 month periods following the surge. The exception was the period following October 1929 which stands to reason given the extraordinary economic headwinds of the era (the Great Depression).

 What does this mean for investors?

If the chart is any indication, a surge in volatility may be one indication that we are seeing the “darkest before the dawn”. It’s very important to note that this analysis isn’t meant to signal that a market bottom is around the corner. Rather, it suggests that periods of extreme volatility like the one we’re experiencing today have tended to represent important turning points in the market.

Of course the standard disclosure always applies in that “past experience is no indication of future performance”, but my view is that history is all of the information that we have to analyze.  Therefore, I take the stance that this compilation of information is better than no information at all.

I suppose that only time will tell if the extreme volatility in the equity markets during October 2008 was yet another indication of a market reversal.  

Chart Courtesy RBC Capital Markets

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Governments in North America, Europe and Asia have provided bailouts to troubled financial institutions, liquidity to money markets and guarantees to banking systems. And all of this is in addition to drastic interest rate cuts. Fortunately, there are some very encouraging signs that these initiatives finally are starting to work.

Some Good News For A Change

Indications that credit is starting to flow

•  The rate at which banks lend to one another known as the London Interbank Offer Rate (LIBOR) decreased from a peak of 6.88% earlier this month to less than 1.3%.
•  The spread between 3-month LIBOR and U.S. Treasuries (the risk-free rate) decreased from a record high 4.65% earlier this month to 2.7% on Friday. A narrower spread means that banks are more willing to lend to each other.

Good news for U.S. housing

•  U.S. fixed-mortgage rates decreased helping more borrowers qualify
•  Variable rates continue to decrease due to Fed rate cuts
•  Oil and gas price declines result in more affordable heating costs for homeowners as we head into the colder months
•  Data from August and September shows reduced inventory of U.S. homes. The 10.6 months supply of homes in August slipped to 9.9 months supply in September
•  The FDIC and the U.S. Treasury are working on a proposed plan to prevent avoidable foreclosures by offering guarantees to lenders and companies that service mortgages

Despite these encouraging signs, we will continue to see volatility as investors react (or is that overreact?) to every new piece of information released.

Facts About Stocks and Recessions

There’s a lot a worry about the recession now. But what’s important to remember is that equity markets tend to be leading indicators of the economy.

Looking back through history, equity markets have typically retraced prior to, and in the early stages, of recessions. Once equities have reached their lows, they tended to rise quickly preceding the broader economic recovery.

So, make sure you don’t let yourself  fall into the mob mentality or you may find yourself missing the upturn in equities.

We don’t know exactly when the recovery will commence, but over the long-term equities has still been the top-performing asset class. And out of all the equities, the dividend growers have been the most stable.