We’ve all seen the data that dollar weighted returns are far below fund weighted returns. That’s because, as behavioral finance has consistently shown, investors have a tendency to act predictably irrationally.
In looking at stocks, since the beginning of 2000, we’ve had two stock plunges of about 50%. In each of these, money flowed out of stock funds at the market lows and funds flowed into stock funds at the highs. In fact, since the last plunge, funds didn’t start returning to stocks until January of this year.
In short, we are hard wired to buy high and sell low, which may have its roots far back in human history. Our species survived by reacting to pain and pleasure - running away from that which brought us pain and toward that which brought us pleasure. It’s not a stretch to apply that same biological imperative to modern investing. When stocks tank, we feel pain, and the best way to make it stop is to retreat from that pain by selling. Conversely, when stocks surge, we seek out this pleasure and buy high.
We always run to asset classes after a surge as well, believing such new paradigms as gold will go up forever, real estate can never go down, or cash-flow no longer matters. The wealth-building potential of these paradigms gives us pleasure, so we want to believe them.
But it is up to advisors to limit the amount of pleasure our clients seek and make sure we steer them toward making the hard, painful choices like rebalancing. That means buying more stocks in down markets like early 2009, and selling stocks when markets are booming as they are today. And when our client wants to buy the hot asset class that seemingly will always go up, we must also deny them this pleasure.
The only way, of course, to explain this approach to clients is through educating them. It won’t make the pain go away but may make it more tolerable. If the client still demands to stop the pain and replace it with pleasure, we must be prepared to be fired before enabling this foolishness.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes the Irrational Investor column for CBS MoneyWatch.com and is an adjunct instructor at the University of Denver.
