Individual Investors Have Poor Instincts

In our last access blog we discussed risk aversion among Generation Y and other investors.  This month we are going to take a deeper look into the sources and rationale for fear among investors, and discuss how letting our emotions take control of our investment strategy can often do more harm than good.

Let’s start with an anecdote from famed mutual fund manager Peter Lynch.   During his 23 year tenure managing Fidelity’s Magellan Fund, Lynch earned an annualized return of about 29%.  Despite the outstanding long term performance of his fund, Lynch estimated that most investors in the fund actually lost money. 

So how did most investors in one of the most successful mutual funds in history end up losing money?  And if so many investors lost money, how come Lynch had such a strong reputation? 

The answer is that poor performance was not Lynch’s fault, it was the investors’.

Lynch was an extremely successful manager, but like the rest of the market, he saw ups and downs.  The average investor in the Magellan fund came into the fund after its strongest periods (lured in by the hopes of getting rich quick) and left after its weakest periods (for fear of losing even more money).   Because they let their greed and fear get the best of them, investors have a strong tendency to buy high and sell low – the exact opposite of what they likely set out to do.

Just as we attributed risk aversion to psychological factors, this tendency to buy high and sell low may be somewhat hardwired into our brains.  Studies have shown that if we see a chart showing a stock on the rise, we have a tendency to assume that the trend will continue.  Conversely, if we see a stock taking a plunge, our intuition is that its value will continue to plummet.  Unfortunately, these tendencies do not play out in real life, and as every investment professional is required to tell you, past performance is no guarantee for future performance.

And it is not just lay investors that fall prey to their emotions.  Each week the American Association of Individual Investors polls the sentiment of its members (not professional investors, but individuals who are very in tune to the goings on of the market).  When markets reach extreme levels (the times our emotions are likely to run highest), these investors become extremely poor at forecasting what lies ahead.  Most recently, in the wake of the financial collapse and the subsequent market decline of 2008-9, AAII members became extremely pessimistic.  Their pessimism reached its highest level in history in the March 5, 2009 survey.  If their intuition was right, markets were in for some nasty times.  Instead, four days later markets bounced off their lows and never looked back.  The S&P 500 index finished this past month up 88% from its March 9, 2009 low.

Investors, however, are not doomed by their intuition.  Careful planning and an adherence to a disciplined investment approach can help even the most anxious investors succeed.  In next month’s blog we will discuss how even the most plain-vanilla investment approach could have earned you money in the recent “lost decade.”