Investing Strategies for an Irrational Brain

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Investing Strategies for an Irrational Brain

Charles Rotblut has a nice article in the latest AAII Journal entitled “Investing Strategies for an Irrational Brain” in which he writes in part:

The tendency to think recent conditions will continue into the future is known as recency bias. History is filled with of examples of recency bias occurring. During the late 1990s, investors willingly bought dot-com and technology companies with little to no regard for their current earnings or ridiculously high valuations. During the fourth quarter of 2008 and the first few months of 2009, investors pulled out of stocks even though valuations were extraordinarily low.

Recency bias is perhaps the most difficult natural bias to overcome.

In our article “How Long Should I Give An Investment Plan?” we wrote, “Even 30 years is not long enough to judge which investment will have a higher mean return for the next 30 years.” One reader commented, “I stopped reading this article at 30 years isn’t long enough to judge a plan. Are you kidding me, that’s a lifetime!?”

If you judge each asset class by its best or worst 30-year period, you would make some serious miscalculations. Take, for example, the statistics for the S&P 500 we analyzed in our article. A return of just 3.91% over a 30-year period is within two standard deviations. If that was accurate, the S&P 500 would not be a particularly good investment. In fact, the S&P 500’s return at two standard deviations below the mean was negative for the past 19 years.

The reason so many people invest in the S&P 500 is because they know to look beyond 30-year returns. When you include as much data as possible, the average annualized return for the S&P 500 is a respectable 7%. The studies supporting the worth of small-cap and value stocks use data going back to 1927.

For some people, 30 years seems like the long-term, but good investors take a longer view. But there is a kernel of truth to our reader’s question. Sometimes, within 30 years, you may have a need that requires you to have a sufficient amount of money in your portfolio at that time. If you happen to be primarily invested in the S&P 500 and are in a rare low-performing stretch, this may be a problem.

This is why good investors take the longer view – they know that stocks trend upwards over time, but that at any time, it is hard to predict what will be up and what will be down. There are five other asset classes besides the US stock represented by the S&P 500. The fact that the S&P 500 can be disappointing for a long period of time is a good reason to diversify into the other asset classes.

Rotblut agrees:

Included in your rules should be guidelines for your long-term portfolio allocation strategy. Specify how much you want to allocate to each major asset class: stocks, bond, cash, real estate, etc. Then define under what circumstances you will adjust your portfolio when it strays away from these guidelines. You may decide to adjust your portfolio allocations whenever one of the asset classes moves more than five or 10 percentage points away from its target. Alternatively, you could segment your portfolio by time, such as keeping between one to five years of money needed to cover living expenses in cash and short-term, highly-rated debt instruments. …

Creating and following predefined rules for selling investments is a good strategy that transcends just behavioral finance. Sell rules reduce the guesswork of determining whether to hold onto an investment, reduce the size of the position or get completely out of it.

Our bias to jump on the bandwagon of what performs well and our bias to avoid what’s going down can distract us from a good long-term investment strategy. Rotblut argues that investors should base their decisions on reason rather than emotion:

One of the simplest and most effective strategies is to simply use the power of the written word. Write down the rules governing how to manage your portfolio, including your long-term allocation strategy, guidelines for determining if a security or fund should be bought, and the specific circumstances under which you would sell. Simply having these rules in place can make a big difference.

Rules regarding how you are going to manage your portfolio are critical. We don’t always know how the markets are going to move. But we should decide ahead of time how we are going to respond in response to market movements. This often means doing the exact opposite of our initial impulse: buy low and sell high.

Set a good strategy and stick to it in spite of the emotions inspired by the normal volatility of the markets. That is the way to building wealth.

Photo used here under Flickr Creative Commons.

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.