Trust Your Instincts – They’re Perfectly Wrong

 

Here’s a viciously revealing statistic: according to DALBAR, for the 20 years ending at 2009, the S&P 500 returned 8.2% annually, while equity mutual fund investors earned just 3.2% per year! Why? Dain bramage. We’ll get to that in a minute.

2010 proved to a reasonably good year for growth assets (stocks, REITS, commodities, etc.), and on the back of 2009’s even better results, investor zeitgeist is once again quickly shifting from Fear to some-intermediary-mood that will soon evolve to Greed. Standard.

In place of the mantra of ’08–“I’ll take a very small yield just so I don’t lose any money”–what I’m starting to hear from investors of all stripes is, “I need to get back to my prior peak in assets” (and of course we all know how much we “used to have,” don’t we?). The thinking is that now that markets aren’t falling any more, risk is gone; time to be overly aggressive! To which I say: pump the brakes. As silly as the paltry CD rates now seem to you, so too might an all-stock approach when the market’s next correction hits.

Investors are nothing if not bipolar amnesiacs.

The most important lesson I can impart to you is this: if you’re at all intelligent and mentally-normal, you have all the makings of a really bad investor. (And heaven forbid you’re a doctor—now you’re a bad investor with overconfidence. That which works beautifully to describe cause-and-effect in the natural sciences does not translate to explaining behavior in the social sciences.) The only antidote is to acknowledge this, and follow the advice at the end of this article.

It’s in our wiring to be bad investors. Despite spending 25 years developing counterintuitive behaviors, even I get tripped up by my brain from time to time. It’s nothing to be ashamed of–just aware of.

The human brain is divided by area into different functions. Contrast the rational, thinking part of the brain versus our instinctual, primal area. Let’s call them Rational Brain and Instinctual Brain.

For the purpose of survival (and thus continuation of the species), Rational Brain cooperates with Instinctual Brain. Rational Brain says, “We’re skiing towards a tree,” and Instinctual Brain responds with, “Danger…for the love of God, STOP THE THREAT!” and makes your heart beat faster to pump blood to the body so it’s ready to react. Rational Brain says, “Got it!” and directs our legs to turn us. Thus, we live to see another day thanks to the cooperation of our brain functions.

In addition to the “Avoid Death” mandate, Instinctual Brain sees that we’re rewarded for other specie-survival activities. Essentially, it wants Rational Brain to figure out what we need to eat, to put together to stay warm, and to copulate with. Instinctual Brain releases the brain’s pleasure compound (dopamine) when it wants to reward us for the right behaviors…and Rational Brain commits those choices to memory.

Oh, and the fear response is 2-3 stronger than the pleasure response, so we’re motivated to do more to avoid pain than avail ourselves of pleasure. All in the name of survival, not portfolio strategy optimization.

Let’s see how this works with investing (oh so badly). When a person experiences declining account values, Rational Brain says, “I’m losing money* and that threatens everything from my standard of living, to how I feel about myself.” Instinctual Brain, which can’t distinguish between physical and non-physical threats, responds with, “Danger…for the love of God, STOP THE THREAT!” While a person is looking at their account online, or listening to some stammering anchor on CNBC, Instinctual Brain may even prepare the body for the fight or flight by creating a rapid heart beat, sweaty palms, nausea, etc., just for good measure. Rational Brain, wanting to quell the fear, says, “Got it!” and stops the threat by liquidating assets.

And when assets are rising, or an investment takes off, Rational Brain says, “I’m making more money and that means I can buy more things/worry about less things, and thus I feel better as a person.” Instinctual Brain says, “Yeah, baby, more of that!” and releases dopamine in order for you to do more of whatever you did to make that money, and drive that rush. Rational Brain says, “Got it!” and commits maximal capital to the investment.

Which brings us back to that DALBAR stat. Equity fund investors earned less than 40% of the annual return of the equity market over the last 20 years. What explains that? Investors respond oppositely of how they should; they buy high and sell low, they’re too conservative at the bottom, too aggressive at the top, and they make changes way too often. The sin of nearly every investor I’ve encountered is not the lack of action, but too much reaction.

My recommendation for those that direct their own investing is that they base their asset allocation on their station in life, their investment goals and their constraints–and not on current or future market conditions. Today, that means letting go of the reckless notion of over allocating to risk assets in a desperate ploy to earn back all the money they’ve “lost” in the decade. You might even emulate the George Costanza approach: listen to your instincts, and do the perfect opposite.

* Often, when assets are declining in price, you’ll actually hear investors refer to this as “losing money”—as if an actual Outflow we’re taking place, implying permanence! This is all part of the distortion the brain creates during periods of financial stress. An investor that’s holding an assets that fluctuates is no more losing money when the asset declines in value than they are “making money” when the asset rises–the only way you “make” money is when someone pays you it (Inflow). Valuation vs. Flow: a problematic investor bias that encourages activity since we’re likely to address something that’s changed for good (permanently) rather than a temporary event.