The psychology of why investors "Buy High/Sell Low," and how to avoid that trap


For 2009, the S&P 500 gained 26.5%, the Dow Industrials gained 22.7%, the NASDAQ gained a phenomenal 45.4% and Barclays Aggregate Bond index gained 6.1%.  European exchanges gained 24-32% while Brazil, India and China returned once in a life time gains of 82.7%, 92.6% and 118.7%.  These were the best results for world stocks since 2003, which, not coincidently, was also the first year following the last bear market.  Yet millions of investors failed to participate in these gains.  Why?  Because they panicked at the worst possible moments last January, February and March, went to cash and have stayed in cash.  Those investors will never make up the gap and will be lucky to retire ever!

Not all our clients could "stay the course."  About a half dozen fired us the first week of March and liquidated their portfolios at 13 year lows.  Another half dozen liquidated their portfolios between July and October 2002 at the tail end of the last bear market.  However, a number of our clients moved excess cash into their investment accounts during the crisis.  We took those clients fully invested by April, and they picked up hefty gains in nine months on those investments.

At least in US stocks, there's never been a bear market that wasn't followed by another bull market.  We can imagine scenarios where stocks don't recover after a bear market.  Those scenarios generally involved investors foraging for food among smoking cities following a nuclear war, for example.  In any scenario where McDonald's still sells hamburgers, GE still sells power plants, JP Morgan still dispenses cash from ATM's and Pfizer still sells Viagra, we would be highly confident that the market will recover.  What information can we, as investment advisors, give our clients to enable them to stand strong during the next bear market?

The DALBAR Quantitative Analysis of Investor Behavior

DALBAR is a market research firm that compiles a bi-annual survey of investor behavior.  We would be delighted to forward a copy of the full 2009 survey on request.  DALBAR analyzes the flows of retail investors' funds in and out of mutual funds as a proxy for overall investor behavior.  For the 20 years ending 12/31/2008, the S&P 500 gained 8.35% (all numbers annualized), the Barclays Aggregate Bond index gained 7.43% and inflation gained 2.89%/year.  So by simply buying an S&P 500 index fund January 1st, 1989 and holding that fund through all the crises of the next 20 years, an investor could have earned nearly 5.5% real return.  The real value of their money gained 289% over 20 years - practically a triple! 

However, investors actually held mutual funds on average only 3-5 years, either jumping out to cash or jumping into hot sector funds, usually after the big gains were already in the bag (think of Internet funds circa 1999.)  As a result, the average investor returns in mutual funds over the same 20 year period was 1.87% for equity funds, and 0.77% for fixed income funds.  Adjusted for inflation, typical investors lost money over the 20 year time frame

Quoting directly from the DALBAR study:

Why Investors Do What They Do

The principles of behavioral finance help explain why investors often make buy and sell decisions that may not be in their best interests, in both the long and short term:

Loss aversion: Expect to find high returns with low risk

Narrow Framing: Making decisions without considering all implications

Anchoring: Relating to familiar experiences, even when inappropriate

Mental accounting: Taking undue risk in one area and avoiding rational risk in others

Diversification: Seeking to reduce risk simply by using different sources, giving no thought to how such sources interact

Herding: Copying the behavior of others even in the face of unfavorable outcomes

Regret: Treating errors of commission more seriously than errors of omission

Media response: Reacting to news without reasonable examination

Optimism: Believing that good things happen to "me" and bad things happen to "others"

End quote

Take a moment to consider the implications of these principles to your own investment experience.  In particular, we are always intrigued how many of our clients want to invest in "hedge funds" or "aggressively leveraged, non-transparent, limited liquidity, co-mingled pools of capital" as we call them.  The marketing of these funds always seems to boil down to the promise of "high returns with low risk," and this promise is only available to the "select few."  In the worst case scenario, investors found out that they were invested with Bernie Madoff.  Even among legitimately operated hedge funds, the mortality rate (closure of fund because of unacceptable principal losses) was about 20% of all hedge funds last year.  By comparison, the mortality rate among boring registered investment advisors such as ourselves was near 0%.

Scenario testing

Much military preparation, whether at level of individual recruits or at the "war game" level, revolves around training for likely scenarios.  For example, if a soldier has already practiced dealing with 20 simulated "ambushes," that soldier is far more likely to react appropriately and survive a real ambush.  We recently developed a series of scenarios for our clients and prospective clients to consider as a way to establish how they really feel about investment risk.

Scenario 1:

You're on a plane preparing land at LaGuardia Airport in New York City during a thunderstorm.  With minutes to go before landing, the plane is suddenly rocked by violent down drafts.  Do you:

A.    Buckle your seatbelt tighter, clutch your armrests and toss a prayer to your personal deity.

B.    Rush down the aisle, kick open the cockpit door and seize controls of the plane yourself.

Scenario 2:

You're at the dentist having root canal.  Suddenly, you feel acrid dust on your tongue and smell smoke.  Do you:

A.    Ask for a moment to rinse your mouth and clear your throat (this will be over soon.)

B.    Grab the drill and finish the operation yourself.

Scenario 3:

You're a defendant in a major product liability case.  If you lose, you could be out $500,000.  After two weeks of trial, the case could go either way.  During the final summation do you:

A.    Rely on your attorney to finish the trial - win or lose, he's the one who went to law school.

B.    Address the judge and jury yourself.

Scenario 4:

Your three year old car develops a case of "mushy" brakes and won't stop as quickly as you expect.  Do you:

A.    Take the car into the dealer for a thorough inspection.

B.    Tinker with the master cylinder, calipers and brake pads yourself.

Scenario 5:

Stock prices have fallen 20% over the last 6 months, and leveraged investors everywhere are vomiting up securities.  On the television, investment analysts soberly explain how you must hedge your portfolio by "loading up on the UltraProShares Triple-Short ETF."  Your brother-in-law is buying gold and dividing his cash up among 6 different banks, in case one of them fails.  Do you:

A.    Hang tight, knowing that you won't draw on your assets in stocks for at least five years, and think about maxing out your 401K contributions a bit early this year.

B.    Fire your investment advisor ("that idiot!") and convert all your stocks to cash.

If you would select option "B" in any of these scenarios, please write a few sentences as to why.

Why CNBC is not good for your financial health

Obviously some of our clients chose option B for the last scenario, even though we're reasonably confident they'd stick to option A in most professional encounters.  What is it about investing that makes clients suddenly think they know more than their advisor in the midst of a financial panic?  In the practices of medicine, dentistry or law, or the occupations of airline pilot or mechanic, there's no mass media devoted to "do-it-yourself" dentistry, legal work, piloting or car repair.  There is quite a bit of mass media devoted to "do-it- yourself" investing.  You can find personal finance columns in all major newspapers and websites, there are dozens if not hundreds of investment newsletters, and of course CNBC plays on the television screens of every bar, health club, airport departure lounge and shoe shine stand in the nation.

A typical CNBC story will lead off with "what stock should you be buying today; what fund should you be buying today; what commodity should you be buying today?"  The proper answer, in our opinion, is the same stock, fund, commodity that you bought three months ago and will be buying three months from now, because nothing in the real world ever moves so frantically as to justify buying and selling in the same week, day, hour or second.  However, that kind of sober, rational analysis, which would lead to very little trading, doesn't pay the bills of all the stock brokerages that advertise on CNBC.  So much of the reporting on CNBC prompts you to "act now!"  We prefer the old fashioned "mosaic" approach, where an investor gathers hundreds if not thousands of data-points before making a decision.  Each data-point is no more significant than a single tile in a mosaic, but thousands combined together produce a very pretty picture.

Probably the most ridiculous segment on CNBC is the "Mad Money" show with Jim Cramer.  We think Cramer's a reasonably smart guy who made a reasonable amount of money for his clients back when he ran a hedge fund (full disclosure: David Edwards wrote the "Portfolio Managers Toolbox" column on the from 1999-2003.)  We don't think he can teach Mr. & Mrs. America to do their jobs, take care of their families, and simultaneously day trade their 401K accounts. 

We do know we can't trade like Cramer recommends, and what's more, we're pretty sure we don't want to.  Cramer has successfully resisted efforts by independent firms such as the Mark Hulbert Financial Digest (a newsletter rating service) to actually track his performance over time.  However, our guess is that at best the performance ballparks around the S&P 500.  More likely, he underperforms given the trading costs and short term taxes that a high turnover trading strategy entails.  Cramer's show is very entertaining with the camera swoops, props and sound effects.  "Scrubs," a comedy about young doctors, is also very entertaining, but we wouldn't watch that show to learn internal medicine.

Our performance, by the way is computed monthly, quarterly and annually, and compared to the relevant benchmark on every client statement.

No one ever mentions on CNBC that the odds of being a successful "recreational" investor are about the same odds as being a successful "recreational" poker player in Las Vegas.  Becoming a successful investor requires a commitment of 40-60 hours/week devoted to research, tens of thousands of dollars spent annually on market data, years of practice and the self-knowledge to recognize that, of the thousands of investment decisions you make over a life time, 40% will be money losing.  Therefore, do you have the discipline to truly diversify your investments?  Can you buy what others sell, and sell what others buy?

Do you trust us (and are you honest with us?)

95% of our clients trusted us when we said "stay invested" through the crisis and were rewarded.  Given how their accounts have rallied in the last 9 months, we expect those clients to start making new highs (relative to October 2007) over the next two years.  Key word is "expect" not "guarantee."   The "real" economy, as opposed to the "financial" economy is recovering fastest in emerging markets such as China, Brazil and India, and also in developed economies such as Australia and Canada where financial game playing was minimal.  The economies of the United States and Western Europe, with the most sophisticated financial systems, took the worst hits.  It's pretty aggravating that bankers in the United States and Europe felt taking record bonuses of about $200 billion this year was appropriate, even though about $10 trillion in wealth was destroyed in 2008-9.  So far, it looks like the world's real economy is recovering even with a crippled financial economy, and that growth would justify gains in stock prices in the 8% annual range.

Do you trust us to keep monitoring your investments, shifting your investments between companies and industry groups, domestic and international markets, stocks and bonds as our analysis and expectations see fit?  If you don't, we'd like to hear from you now while markets are calm.

Are you honest with yourself about what's reasonable from an investment portfolio?  Our best guess is that a properly diversified portfolio of stocks, bonds, mutual funds and ETF's will return less than 8%/year over the next decade.  For years, we told our clients who draw upon their portfolios for retirement income that 4% (of the total value of a portfolio) is the conservative annual draw rate and 7% is an aggressive draw rate.  We were thrilled that we didn't have to cut anyone's "allowance" over the last year because we required our clients to be conservative when times were good.  A portfolio that gains 8%/year doubles every 9 years.  A portfolio that gains 20% for 4 years and loses 50% in the fifth year leaves you right where you started.  Don't ask us to build you a portfolio that will outperform the S&P 500 in a bull market, deliver money market returns in a bear market (if there was such a strategy, everyone would follow it.)


As we proceeded with our transformation to a wealth management firm, we concluded that we can't rely completely on our clients to educate themselves about financial matters (everyone has a busy life, and let's face it, most financial journalism is a good cure for insomnia.)  In addition to our monthly market commentaries, we will also distribute short "strategy" pieces on topical issues.  Over the next several weeks, look for e-mails on subjects such as "A Financial Self-Assessment," "The New Roth IRA rules," "Estate Planning in 2010," "Timing Social Security Distributions."  Also, we'll be introducing more of our clients to the "Full View" tool on  Some of our clients are using this tool already, but in brief, "Full View" allows you to see all your financial affairs, whether brokerage or mutual fund accounts at other firms, your 401k, checking accounts, debit and credit cards and mortgages all on a single "dashboard."  Good information drives good decisions!