Friday, November 21st, 2008
The markets took another beating yesterday with the S&P/TSX plunging 756 points to fall below the 8,000 mark for the first time since 2003, closing at 7,735 and the DJIA fell 360 points to close at 7,637. The events of this week are sure to keep investors questioning their actions or inactions with respect to their investments and whether or not they should ‘do something’.
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.
Wednesday, November 5th, 2008
A few weeks ago I wrote an article titled Panic or Profit and many folks thought I was just spouting theory. While that may be, the recent evidence of my “theory” has been proven at least half true thus far.
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.
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?
Friday, October 24th, 2008
Is it just me, or does it seem like the media is playing a large part in the widespread financial panic that has consumed the globe?
I know the media is in the business of selling “papers” but still I wonder why they always seem to play up the negative? This only serves to feed the panic and thus make an already irrational market further disconnect from the fundamentals.
Is there any time when they should consider playing up some of the positive stuff, like companies that continue paying dividends, increasing liquidity, interbank credit easing etc. instead of feeding the panic.
Is A Balanced Representation Too Much To Ask?
I am not suggesting for a moment that they hide the truth. However, all we are really getting is an opinion and interpretation on what is happening – but does anyone really know what is happening?
The average person on the street panic and because of the sensationalism of the situation portrayed by the media, cannot differentiate between opinion and facts. The average Joe may panic and liquidate his 401k and not even really know why he is selling, other than the fact that the media is bombarding him with messages of companies going bankrupt and people losing their life savings etc.
Worse yet, a study found that increased suicides and homicides are linked to the financial “crisis”.
An out-of-work money manager in California loses a fortune and wipes out his family in a murder-suicide. A 90-year-old Ohio widow shoots herself in the chest as authorities arrive to evict her from the modest house she called home for 38 years.
In Massachusetts, a housewife who had hidden her family’s mounting financial crisis from her husband sends a note to the mortgage company warning: “By the time you foreclose on my house, I’ll be dead.”
Then Carlene Balderrama shot herself to death, leaving an insurance policy and a suicide note on a table.
I certainly don’t have all of the answers, if any at all, to these issues. However, I am becoming very disheartened with the mainstream media as they continue down a path that leads to more destruction that good. The above shows the outcome ofpeople feeling hopeless about their situation, financial or otherwise. Media outlets fuelling such hopelessness certainly doesn’t help.
Front page headlines do not necessarily need to be filled with hope, but I believe the media owes the public the opportunity to receive sound and relevant news about the state of the economy and their personal finances.
What Would It Take?
What would it take for the major media outlets to band together for the greater good of our global society and present quality information that would help to instill the appropriate (read: more rational) level of confidence in our monetary system(s)?
I know that much of the turmoil in the financial markets is real. However, for media outlets to portray this as the “financial apocalypse” is absurd, and in my opinion, unethical. Yes, there is cause for concern about the economy and the financial markets, but the infusion of undue fear on to the public is shameful.
At a time when media sources could be encouraging us to learn more about our economy and educate ourselves on personal finance, credit, and investing, they choose instead to churn out headline after headline proclaiming the next depression and the longest deepest recession in history etc.
One must wonder if there will ever be something bigger at stake than selling papers?