This month I would like to write about the behavioral finance part of the market, a part that has become more important due to major volatility and continuous news about the economy and the stock market. Behavioral finance is that part of finance that studies people’s actions and beliefs when faced with options and choices in the world of finance and investments. It looks at their actions and identifies irrational financial decisions that are common amongst us but that we believe are just and rational, when in fact they are just harming us. Behavior finance is still gaining support in the finance circles and is being recognized as an important factor.
As decisions are made by people, the thinking process and the psychology of it, especially when it relates to money, is very important to understand. Many books have been written about our own biases, fallacies or assumptions we make when we invest and at times they hurt our long term performance. Today, I will discuss about one of those biases and what could have happened if we didn’t fall victim of this bias. I am talking about news and noise, TV commentaries, friends’ advices, neighbors’ recommendations and many other ‘experts’ that at times tell us what’s hot and what’s not. Vanguard has done research of what a balanced portfolio (60% stocks / 40% bonds) would have performed over the past 6 years (since the start of the financial crisis) if we had done NOTHING, but maintained our plan and allocation set from the beginning.
Much news has happened and gone since then, and we have heard from all points of views; how to sell at the bottom in march of 2009, how equities were doomed, how to buy emerging markets as they would outperform, how to sell Europe in late 2011, how to never own Japanese stocks in early 2012, how to recently buy stocks etc, etc. Vanguard is showing that a ‘noise-free’ portfolio that stood firm and didn’t follow the latest news did better than most. Vanguard demonstrates that such portfolio (even though constructed looking back) has outperformed most ‘follow the news’ portfolios, news that in reality haven’t actualized.
Most of us know, ‘when it’s news it’s too late’, but we still fall prey to such behavior. One fallacy that is known is that we put a lot more weight to a recent event rather than a further out past one, overweighing what just happened vs. what has happened in the past. It’s like our memory can only retain so much. Advisors and clients alike fall for this bias and we all are ‘at fault’ for not realizing that we are putting too much emphasis on the most current event or news, while completely disregarding known history of hundreds of years of performance and trend lines.
Some lessons we all can take from this is that: Your plan is yours, not your friend’s, not your neighbor’s and not your TV anchor’s. If you have built an asset allocation with your advisor that has considered your risk tolerance, time horizon and is fairly well balanced and diversified, then, your portfolio, over the long term should perform in line with the average trend line for the amount of risk taken. Sure, at times, we have crises and major stock market sell-offs, but we also have (maybe in the not so recent memory) double digit return years, significant earnings growth, new technologies and improvements, new business lines, new customers and more.
As advisors and clients, at times, we just want/need to react to some news as it is happening, thinking it’s the best thing to do in light of the new situation. It’s always recommended to review your plan periodically or when changes to client’s situation happen, but other than that, most of the time, the best thing to do is NOTHING. By doing nothing, you are actually making a decision to stick to the previously approved plan and not follow the latest news and noise, which after all happen to be mostly NOISE. Just turn the Noise OFF.
Lead Advisor, InvestEd.