I believe that psychology can play a tremendous role in determining just how successful the average person's investment program will turn out.
Investing involves making decisions. Often, we make our decisions based not so much on any objective facts we have gathered in evaluating an investment, but much more on the basis of the following three subjective factors:
a) Our personal judgments as whether to any facts we may have gathered in evaluating the investment are either "good" or "bad" with regard to the investment.
b) Our feelings of "latent" inadequacy in the area of investing, resulting in a tendency to seek out expert, "in the know" opinion and to assume that what the masses are doing must somehow by definition represent the correct approach.
c) Our tendency to act upon a currently experienced emotion without putting it into its proper perspective, that is, to overgeneralize it.
But just how well do these subjective processes serve us when we are making our investment decisions?
Every time we decide to either make or not make an investment, we ultimately are making either an optimistic or pessismistic assessment with regard to the future. But in a perverse kind of way, in the world of investing, what may appear at the time to clearly suggest a one-sided conclusion may eventually result in a completely opposite outcome, and vice versa. Examples abound:
And on and on.
The way these things all seem to work is this: We want positive evidence before we invest. But since investment results are often cyclical (that is, go from down to up and then retrace back down again), once enough evidence is known that can clearly be recognized as positive, the seeds may have already been planted for the types of conditions that can lead to just the opposite.
Most people, especially when just starting out, do not have much confidence in their own ability to successfully invest. Inwardly, these people do not want to have to shoulder the heavy responsibility for making their own investment decisions for fear that they won't do the right thing and that they will have no one to blame but themselves. (And for those who have already witnessed the kind of perversity within the world of investing I have described above, it can be easy to understand why.) Therefore, most of us seek to acquire some form of "expert" opinion. Although I would certainly not agree with some skeptics who suggest that such opinion offers no real value, it must be recognized that everyone, including the experts themselves, are subject to the same kinds of sometimes distorting psychological processes that can impede, rather than aid, investment performance.
When we are faced with ambiguous decisions, we often make the assumption that what the masses are doing must somehow be correct. In investing, the most obvious measures of mass opinion are asset prices themselves. That is, high asset prices are frequently used as the single best piece of evidence that an the investment must be good. But by the time prices are high enough to capture many people's attention, these individuals may be buying near the top, or an inevitable downturn may be near.
Success with a particular investment can to lead to excessive confidence in that investment. Mutual fund investors are much more likely to buy an investment that is going up in price than one that is going down. This often leads to buying at just the wrong time as the cyclical nature of investing rears its ugly head.
Likewise, feelings of fear are induced as net asset values enter what the investor dreads will be a prolonged drop or a period of sub-par performance. As such fears become pervasive, they prevent people from seeing such situations as buying opportunities, or cause them to sell prematurely before prices have had a chance to recover. Or, perhaps due to their earlier overconfidence, these investors are now already fully invested and are unable to buy more even if they do realize that it might be a buying opportunity.
Our natural psychological inclinations often seem to put us at odds with the principles of successful investing, and therefore, stack the cards against ourselves. Usually, the more you can go against the kind of natural feelings I have described above, perversely, the more chance there is that you will be successful. I have already mentioned several strategies for counteracting these feelings in some of my previous newsletters.
---In a similar vein, I have an rather shocking confession to make. Every day, even though I have more than my share of conventional mutual fund investments, I wake up hoping that the stock and bond markets will go down. Yes, down. Don't get me wrong - I, like the average investor, will see the value of my portfolio go down every time this happens, at least on paper. But I just can't help it. Am I deluding myself? I don't think so. Here's why.
Sure, a rising stock market and to a lesser degree higher bond prices, are ultimately necessary for making good returns in your investments. But, over the relatively short term, in order to actually profit from a rising market, you must be ready to sell at the time of the rises to lock in these gains. Otherwise, your paper profit now will not guarantee you a profit later on. So, a rising market is really only clearly good for you if you bought a fund at a lower price and are ready to sell during the rise to capture that profit.
But suppose you, as a long-term investor like me, have no particular plans to sell the majority of your portfolio no matter how high the market goes, nor no matter how low either. Perhaps this is because you are saving for your later years, so cashing out now doesn't make any particular sense. Or, perhaps you feel you are already paying enough in taxes that you are very hesistant to sell while you are still in your peak earning years. The longer you wait, the longer you can defer taxes until you are perhaps in a lower tax bracket, allowing all your money to continue to work for you for all the years you wait. And suppose you are investing regularly as part of your work retirement program and/or into funds in regular taxable accounts. Under these circumstances, rising prices, while giving you the courage to continue with your program, may actually be reducing your future returns by raising your average cost per share. After all, it is the average cost per share which will actually determine just how profitable your investments will be at the time in the future that you do really cash them out. And lower asset prices can certainly create added buying opportunities, something that appears to be notably missing in the U.S. stock market and bond markets today.
Am I willing to go as far as betting that stock and bond prices will come down from here? Trying to outguess the markets' short term moves is, as far as I am concerned, only a fool's game. But I can always hope.
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