When the stock market made a dramatic decline at the beginning of the millennium I was a registered investment advisor working in Northern California. Fortunately I was still teaching finance courses part-time at California State University, Chico and was grateful each day when I left the office for the classroom because it meant a break in the scared phone calls. My normally positive-thinking clients were scared about their futures in a way they had never imagined.
Most of my clients were baby boomers who were accomplished professionals at the top of their game. Prior to the stock market drop they were urging me to invest in risky assets as the market skyrocketed on its way to the Moon. When the markets reached the Moon, they wanted Mars. Unfortunately, they never got there.
When the market turned and started heading south my confident, educated, professional clients wanted assurances that this would all “go away soon”. Sadly, I could not give them the hope they were seeking. The best I could say was “stay cool”.
Let’s take a moment to think about that time. I created a chart on the Dow Jones Industrial Average from 1945-2010 that I have included with this article. Open the chart and take a look at the arrows. The arrows point the years from 2000 and 2003. These are the years that many of my clients asked me to do what all advisors were getting ask to do, the unthinkable; sell when the market had fallen to its lowest level.
After cautioning my investors of the dangers of their buy high, sell low strategy, they issued the orders to sell. Next came the difficult decision. What they wanted to do with the liquidated assets? Some of them indicated they wanted to park their cash in low-paying money market accounts or CDs. They were no longer comfortable with risk.
However that was not the number one response of my clients. The number one response that I heard was “I am going to invest my assets in real estate because there is no risk!” As you might expect, I was shocked by this statement.
Risk and Returns in Real Estate
My father, grandfather, and most of my uncles were builders. As a young girl our whole family experienced the risk builder’s face when newly constructed homes sit around unsold for months or years.
Later in life, as a title searcher at 19 years old I saw layoffs in our office when interest rates went as high as 18%. To add to my understanding of the risks associated with real estate, when I was a university lecturer one of the courses I taught was risk management. I know that when there is the possibility of a return, there is risk.
Since we are all painfully aware of what happened in the real estate market since 2006; we can simply say it has been devastating to millions and millions of people and institutions. Apparently, the investors had mis-perceived the risks.
So now where are the markets going?
Studies show that very few people in the world can, with any consistent degree of success, predict where markets are going. This is particularly true of people who are investing without the assistance of multivariate statistical models and a staff of computer scientists and MBAs.
Personally, I am an MBA, computer scientist, can perform multivariate statistical analysis, and still I do not try to predict markets. Instead I focus on something that many researchers argue is more important than predicting markets. I focus on my financial behavior.
Focus on Me, not the Markets
Does it make sense to focus on behavior and not focus on the markets? To answer this question I will turn to sports to illustrate why I believe that focusing on investor behavior is more important than focusing on the market(s). I use sports because as with investing, we have matches (markets) and we have competitor behavior.
Consider how the athlete spends their days, weeks, months, and years. Is their attention and focus on the match or their behavior? The match includes internal factors (performance during the match) and external factors (weather, competitors, etc). The athlete’s behavior includes how they train, when they train, and more.
The successful athlete has to control their behavior because that is how they 1) create the opportunity to compete and 2) increase the likelihood that they will win the competition. A runner does not spend their time sweeping the track and praying for good weather. They spend their time with their discipline (behavior).
It’s bigger than financial planning
Investors need to focus on the factors they can control, and that is their investment behavior. In fact, the only way to influence a market is through our own behavior. As a graduate student I was fortunate to study finance from Dr. Robert Olsen. According to the Journal of Behavioral Finance, Dr. Olsen ” . . was one of the first to apply the psychologically based Psychometric Paradigm to the study of investment risk.” This is certainly not the same as financial planning.
Behavioral finance focuses on the impact that social-psychology has on investor decision-making and market fluctuations. It is so important that is has become the theoretical basis for technical analysis in the field of investments. It is from my studies in this field, and my time working with clients that guides me as a financial manager.
Simple Truths: What I Learned
1) If You Lose Once, You Will Always Lose.
That is a dramatic statement and it is intended to make a point. Researchers studying behavioral finance found that investors repeat patterns. If investor x sold stocks at a loss in a stock market downturn, chance are they will repeat this pattern again and again. If the same investor sold real estate at a loss in a real estate market downturn, chances are they have, or will, repeat this pattern again and again.
The point is to take a look at your decision today in relation to all your decisions. Have you sold at a loss before? If so , are you always going to lose and not gain? If you take a loss this time what happens next time you are facing the same decision?
Study your behavior in the market. The market does not determine your gain or loss, your behavior in response to markets determines your gain or loss. Learn about and control your investment behavior. Engage in patterns of gaining and not patterns of losing.
As an example, I know a middle aged man who worked in construction and in 2005 he started working for a large construction firm. This man was confident that he was at the top of this game so he bought an expensive house. Within a few years he almost lost (sold) the house when he was laid off from work when the industry collapsed.
This man was encouraged by his father to sell this house at a loss, arguing that the man was being emotional, sentimental, and prideful. The middle aged man ignored his elderly father’s advice and did everything he could to not sell at a loss. A few years later, after making tremendous sacrifices he found a job and is now able to meet his monthly mortgage obligation from his paycheck. I respect the man’s decision to hold his investment until he can sell at a gain and believe he was not being emotional/sentimental/prideful. I believe he is doing a fine job in developing patterns of gain, and not patterns of loss. This to me is more about discipline than emotion.
2) Investing Is Often Counter intuitive.
One of the most fascinating aspects of investing is how counter intuitive it is for most/many people. When I taught investments I would ask my students a question about kayaking to illustrate this point. Imagine you are kayaking down a river with your friend. You are paddling behind your friend when you see him/her point up ahead to the 10 o’clock position (left). How you respond to this communication is based on what you believe they are trying to tell you.
When I asked my students why they thought the kayaker was pointing, they consitently replied that the kayaker was pointing to “a rock”, “a tree”, or “an animal”. They believe s/he was pointing to a hazard or danger. The truth is, if the lead kayaker is trained, s/he is pointing to safety. Therefore, the second kayaker’s correct course of action would be counter intuitive for most people.
How does this apply to investing?
Remember I said investing for most of us, is often counter intuitive. Much like an inexperienced kayaker, unless we are well trained we are likely to act in a way that will increase our risk without increasing our expected return.
Since we can’t rely upon our instinct what can we do?
A. We need to listen to knowledgeable, educated professionals who know how to point us to safety. Resist the urge to listen to your friends and others who are probably making the same mistakes you are making.
Consider two inexperienced kayakers who come upon an obstacle. When they are busy pointing to the danger they are not busy looking for safety. By doing so they’ve decreased the likelihood that they will safely navigate the waters.
B. When you feel it is time to buy or sell think about your actions. Is the market high or low? Would you gain or lose with your decision? If you know you are going to lose, do you need to do it? Trust me, it is not easy to get your head to make these decisions; but if you don’t your feelings will. These feelings are often counter intuitive.
3) The Crowd Is Not Always Right
I suspect you would agree that when our friends are buying or selling investments like crazy, we feel more comfortable buying or selling. In finance we learned from the field of social psychology that we feel safer in numbers. *** This does not mean we are actually safer; it means we perceive ourselves to be safer. The real estate investors who perceived that real estate investing was risk-free made decisions that were not consistent with the truth of the risks.
In finance my favorite strategy to study and discuss is a Contrarian strategy. A contrarian investor attempts to profit by investing in a manner that differs from the consensus opinion. Contrarians believe that more often than not, the typical investor is wrong. Given this belief they look in the opposite direction than the crowd is looking.
Let’s assume the average baby boomer believes this is a good time to buy real estate. What would be a contrarian strategy? A contrarian strategy might be to sell real estate. Would you be surprised to learn that in many real estate markets even though there is an abundance of foreclosure listings, there aren’t many “straight” sales? In these markets sellers who bought a number of years ago can still sell a house in less than three weeks, receive multiple bids, and walk away with a gain.
Investing is counter intuitive which means that we need to resist the urge to rely upon intuition and the behavior of others.
4) Gain And Loss Are A Matter Of Perspective.
Every knowledgeable financial advisor and CPA knows that this statement is true when it comes to financial and real estate markets. There are two aspects of perspective that I want to discuss. The perspective of time and the perspective of the investor.
Perspective of Time
You and I can sell our shares of the DJIA on the same day and yet I may have a gain and you may have a loss. The factor that determines whether I gain or lose is the purchase price (when I bought the shares). Consider the real estate investor who purchased residential property in 2000. According to the researchers at Zillow , they would have paid $127,000 (national real estate values). Today that property would be valued at almost $190,000. Would they realize a gain? From the perspective of time the answer is yes^.
Perspective of the Investor
Take the investor in the above example. Let’s assume the investor could sell the house today and walk away with a gain between $25k-$63k. That is a 19%-49% gain on their investment over time. Is the investor aware of the gain? If this investor is like most, they are aware of the gain but are focusing on what they did not gain (the gain they did not realize). They feel they have “lost out” and don’t feel successful. They are discouraged, disappointed, and reluctant to sell because they “.. could have gotten so much more!”.
From the perspective of time the investor has been successful in realizing a gain. From the perspective of the investor, they were not successful because even though they know logically they had gained, they emotionally could not accept this gain as a success.
Let me provide you an example. One of my neighbors recently put their house on the market and a month later it was sold. When I asked him about it, he seemed disappointed. The man purchased the house a number of years ago when he was transferred to this community. He bought a house in the hopes that he could sell it later when he was sure to return to his home town. In truth, that is exactly what happened. So why was he so discouraged? The man did not consider the move a success because if he would have sold a year earlier (when his neighbor had), he would have made more money. The man met his goals and yet did not feel successful.
Just like the monkey who won’t release the berries in their hand so they can pull it out of the box, it is important that we let go of what we could have and accept what we DO have. The perspective of time is a better determinate of success than is the perspective of the investor. Success is not determined by the fish that got away, it is determined by the fish that are caught. Practically, this may mean that if you can realize a gain at a particular point in time, you may want to do so. Just because others are not gaining (crowd behavior), does not mean you are not gaining. Establish quantitative goals for your investment behavior and base your buy/sell decisions on what is, rather than what isn’t.
What Does This All Mean?
This very brief, over-simplified article on a few important concepts does not provide you with answers to all your investment decisions. My intention in this article is to help you relax and not worry so much about the market. As an individual you are powerless to it.
The good news is that even though this powerlessness it is frustrating, there is something you can do that is even more important. You can focus on your behavior. Your patterns of behavior, your knowledge of investing, and your perspective are within your control and the behavior, not the markets, determine your success. The winning athlete sets goals, focuses on their behavior to attain those goals, and when they are awarded a silver metal they don’t turn their back on it because it is not gold. The successful investor focuses on their patterns of behavior, learns the facts of investing, and focuses on their success and not the success of others.
Where to Learn More
There are numerous books, articles, and journals on the topic of behavioral finance. I recommend these books to start:
Beyond Greed and Fear: Finance and the Psychology of Investing (Hardcover) by Hersh Shefrin
Stocks for the Long Run, 4th Edition: The Definitive Guide to Financial Market Returns & Long Term Investment Strategies by Jeremy J. Siegel