Do you trust your instincts when it comes to investing? If so, you are probably making a mistake. Let me explain and conclude with some advice on how to grow your nest egg by doing the opposite of your instincts.
A point I tend to harp on is that nobody can predict what the stock market will do. Not me, not you, not your financial adviser, not the pundit du jour on CNBC or Bloomberg. And it's important to accept that fact as true — because it is.
However, there is something nearly as important that is totally predictable: investor behavior. If stocks surge, investors will buy more stocks or stock funds. If they plunge, investors will sell. Duke University Professor Dan Ariely describes this behavior best in the title of his book, Predictably Irrational.
And nothing illustrates this behavior better than a simple sketch by Carl Richards in his book, The Behavior Gap.
Here's my narrative of this sketch. The stock market goes up and neighbors tell us how well they are doing. Since we now think the stock market water is fine, we dive in. All is well until a market plunge comes along, with the requisite nonstop media commentary on the new paradigm. This acts as the whistle that tweets "Everybody out of the pool!" We convince ourselves that we are acting logically and sell.
The market then recovers. We blame others for our mistake and get back in, convincing ourselves we won't make that same mistake. But based on what I've seen again and again, the best predictor of whether one will sell after a market plunge is how the investor behaved during the last one.
According to recent research by the fund giant Vanguard, the average investor loses nearly 2 percentage points a year through poor stock market timing. And if you think financial advisers do any better, think again. TD Ameritrade disclosed the bad timing of the 4,000 advisers on its platform during the last cycle. At the very height of the stock market, on Oct. 9, 2007, the advisers had only 26 percent of their clients' money in cash and fixed income. By the market bottom, March 9, 2009, they had nearly doubled this allocation to 51 percent. So their clients got a far larger exposure to the plunge than the recovery.
Why we behave so badly
I teach behavioral finance to financial planners, CPAs and attorneys. As part of the class, I ask them to describe what money means to them, and typically I get responses such as:
Money represents stored energy that powers our dreams for the future. Money may not buy happiness, but this stored energy gives us the freedom to pursue it.
Back in 2007, with stocks at an all-time high, our stored energy was growing and that freedom was ever closer. So we selectively ignored any warning of a bear stock market and bought the argument that real estate could never decline. We shifted our portfolio more heavily toward stocks in order to reach independence even sooner.
But after the 2008–09 plunge, we saw much of our stored energy depleted, and the number of years we had to work to recoup our losses increased. We bought the predictions of a great depression ahead. "Cash is king" was uttered by so many experts that sheer desperation drove us to sell at the bottom. Even the slight market decline in the first few weeks of this year had some behaving badly.
How to behave better
It's not so easy to break the cycle of fear and greed. Admitting that this bad behavior is human is a good first step. The key is to pick an overall stock allocation you can live with and then stick to it, no matter how you feel or what the media are saying. Now that stocks are near an all-time high, you may be thinking you are more risk tolerant than you are.
See also: Are Wall Street adages worth following?
Pull out some of your brokerage statements from late 2008 and early 2009. Did you behave badly? If so, consider a more conservative allocation that will make it less difficult to behave better during the next plunge.
Allan Roth is the founder of Wealth Logic, an hourly based financial planning firm in Colorado Springs, Colo. He has taught investing and finance at universities and written for Money magazine, the Wall Street Journal and others. His contributions aren't meant to convey specific investment advice.