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Behavior and Finance

With the Dow over 13,000 market mania is beginning once again and I feel like I am watching a rerun of an old movie --- a movie when everyone was chasing tech stocks and starting investment clubs at a market high eventually watching their portfolio dwindle as the market fell. Here we go again.

Why is that? Why do so many investors lose money only to repeat the same cycle and lose money time after time? Well, a whole new field is examining that- it is called Behavioral Finance. A study conducted by Yale University economics professor Robert Shiller found that at the peak of the roaring 1980s, 14 percent of Japanese investors expected a crash. After the crash, 32 percent said they expected a crash. This illustrates the tendency for investors to become more optimistic when the market goes up and more pessimistic when the market goes down. It’s this tendency that cause large numbers of investors to consistently buy high and sell low. This evidence challenges the efficient market theory which holds that individual investors act rationally and consider all available information in the decision making process.

In his book, Against the Gods, Peter Bernstein states that considerable evidence “reveals repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty.” We just have to look around to see that our lives are groundless and that nothing is for sure.

You can avoid these mistakes by identifying and understanding some of the common misjudgments that investors make:

Stop waiting to break even –cut your losses and move money to a more promising investment. Most people don’t want to admit that their original buying decision was a poor one. Get over it. Sell and move to what is right for you. Effective portfolio construction should focus on the relationship between asset classes not on individual security selection.

Don’t watch the market; watch your portfolio. You should be optimistic when the market is up and optimistic when the market is down- that’s a sign of a well diversified portfolio.

A poorly diversified portfolio faces higher risk and lower returns. Your neighbor may strike it rich with a single stock or asset class but you will win with consistent long term success.

Lose the attachment to what you own. I see a lot of this with real estate holdings or stock that was inherited or company stock options. It may have been good over the last five years, but will it perform well in the coming years? Maybe and maybe not-but do you want to bet the farm on it? Be open to rebalance every one to five years. Decide what your target asset allocation is (such as 60% equities-40% bonds) and stick with it until your situation changes (like early retirement).

A well constructed portfolio has diversification across asset classes, and an asset allocation that quantifies the risk you are willing to take with the return that you are projected to get. You can get a free portfolio checkup at any brokerage firm such as Schwab, Ameritrade, Vanguard, or Fidelity. (Just be prepared for the sales presentation after you get the report.)

News Flash! – Because of all the spam filters, I need you to formally subscribe. So click on the subscribe link now and I will send you a free PDF file called -Choosing the Right Investment Benchmarks.

Your feedback is always welcome and appreciated! Write to me at fern@wholeheartedway.com.

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April 2007-- this column is produced by Whole-Hearted-Way and provided by Fern Alix LaRocca CFP® EA.