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November 29, 2006

Where Fools Rush In

Regular readers will be intimately familiar with my theme of buying when everyone else is selling and selling when everyone else is buying. This is a cornerstone of the way I invest. Another cornerstone is that no one can consistently time the market or pick stocks. That means finding a long-term investment strategy and sticking to it irrespective of short term events.

 

An article by Michael Mauboussin, Chief Investment Strategist for Legg Mason and author of the book "More Than You Know: Finding Financial Wisdom in Unconventional Places" in the December issue of Time discusses our proclivity for buying at highs and selling at lows.

 

That proclivity is best illustrated by Dalbar's Quantitative Analysis of Investor Behavior which I quote often. According to Dalbar (Mauboussin attributes it to Jack Bogle but he is quoting Dalbar) in the 20 years ending in 2005, the S&P 500 index rose 11.9% annually and the average mutual fund 9.7%, but the average investor realized only a 6.9% return. (See update at the bottom of the page for more on this.)

 

Mauboussin points to two concepts to explain our behavior. The first is recency bias. Recency bias causes us to put more empahsis on what has happened most recently and minimize, or even ignore, facts and long-term data.

 

He also suggests that we pay little attention to nagging details but instead let the stories spun by Wall Street or the financial press capture our attention. He cites the recent run-ups in real estate and energy as examples saying, "More often than not, once a sizzling sector comes to the attention of an individual investor, the opportunity is gone."

 

We are hard-wired to be poor investors. That is the gist of behavioral finance. But what you have to be aware of is that Wall Street uses that to its advantage. Quoting Mauboussin:

 

If you think the investment industry is there to protect you, think again. Many firms see a hot sector as an opportunity to gather assets. Before the tech-stock peak in 2000, the industry marketed nearly 500 technology, telecom and Internet funds. It's the same story now, only the actors have changed. In October 2004, 180 hedge funds were dedicated to energy and commodity investments. Today there are 525.

 

There's nothing new about bad timing and Wall Street's willingness to accommodate it. In fact, poor timing may be one of the most systematic and predictable errors investors make. Famed portfolio manager Bill Miller has dubbed it the "five-year psychological cycle." Investors want to own today what they should have owned five years ago. Currently, investors are pining for energy and commodities, but they should have owned them in the early 2000s, when they were cheap and unloved. Instead, investors coveted the high-flying tech and telecom stocks, which would have been smart purchases in the mid-1990s--except that investors were busy chasing bank stocks, which would have been shrewd purchases in 1990. You get the idea.

 

People not only do this with hot sectors and hot stocks, they also do it with asset classes. The time to jump in the stock market is not after it has risen 20%. And the time to sell stocks and buy bonds or go to cash isn't after it has fallen 20%.

 

This is the idea behind portfolio rebalancing, a simple but fundamental aspect of portfolio management that very few individual investors do.

 

I am curious what your thoughts are on this topic. Are you inspired to agree? Disagree? Do you have an example? Feel free to share. Comments are welcome in the comment section below.

 

UPDATE: (11/29/06) I received an email from Michael Mauboussin. I said the numbers in the second paragraph should be attributed to Dalbar, not to Jack Bogle. I was wrong. He tells me he WAS quoting Bogle, not Dalbar. Apparently they come up with different numbers. Although the message in them is the same I think. Sorry Michael for the mistake. Thanks for taking the time to set me straight on that one.

 

SOURCE:

 

1. Michael Mauboussin. "Where Fools Rush In." Time 6 November 2006, A44.

http://www.time.com/time/insidebiz/article/0,9171,1552055-1,00.html

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

 

Tags: contrarian investing, Dalbar, Legg Mason, market timing, miachael Mauboussin, More Than you Know, Quantitative Analysis of Investor Behavior, recency bias, sector rotation, stock picking

Posted by Kim Snider on November 29, 2006 | Permalink

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