That’s the title of a Jason Zweig article for the Wall Street Journal. In the article, he points out how investors over-react to short-term information.
According to new research, this area of the “rational” brain [frontopolar cortex] forms expectations of future rewards based largely on how the most recent couple of bets paid off. We don’t ignore the long term completely, but it turns out that we weight the short term more heavily than we should – especially in environments (like the financial markets) where the immediate feedback is likely to be random.
In short, the same abilities that make us smart at many things may make us stupid when it comes to investing.
For the ultimate in over-reaction, he writes:
For quick confirmation, look no further than this recent study, which analyzed the accounts of nearly 1.5 million 401(k) investors and found that many of them switch back and forth from stocks to bonds and other “safe” accounts based on data covering very short periods.
You might argue that the long run is nothing but a string of short runs put together, or that you can get peace of mind by limiting your risk to fluctuating markets when prices fall, or that major new information should immediately be factored into even your longest-term decision-making. But many of these 401(k) investors were overhauling their portfolios based entirely on how markets performed on the very same day.
Yep—by “very short period,” he means the same day. That’s what the authors in the academic article, Julie Agnew and Pierluigi Balduzzi, found. They write:
We find that transfers into “safe” assets (money market funds and GICs) correlate strongly and negatively with equity returns. These results hold even after controlling for lead-lag relationships between returns and transfers, day-of-the-week effects, and macro-economic announcements. Furthermore, we find evidence of contemporaneous positive-feedback trading. That is, we find a positive effect of an asset class’ performance on the transfers into that asset class on the same day. Overall, these results are surprising, in light of the limited amount of rebalancing activity documented in 401(k) plans. It appears that while 401(k) investors rarely change allocations, when they do so their decisions are strongly correlated with market returns.
This is a very polite way for academics to say “when the stock market went down, investors panicked and piled into ‘safe’ assets.” Jason Zweig’s article points out that people react to how their last two trials worked out. That’s pretty much in line with anecdotal stories that buyers of profitable trading systems will stop using them after two or three losses in a row. The long-term is ignored in favor of the very short term.
With typical understatement, Agnew and Balduzzi write:
This is potentially worrisome, as it suggests that some investors may deviate from their long-run investment objectives in response to one-day market returns. We provide evidence that these deviations can lead to substantial utility costs.
“Substantial utility costs” in plain English means investors are screwing themselves.
Now, none of this is a surprise for advisors. We all have the same discussion with clients during every decline. The party line is that more investor education is needed, but these neurological studies suggest that people, in general, are just wired to be bad investors. They might overemphasize the last two trials no matter how we educate them.
So what is the takeaway from all of this? I certainly don’t have a simple solution. Perhaps it will be helpful to reframe what a “trial” is for clients as something much bigger than the last couple of quarters or the last two trades. It might help, at the margin, to continue to emphasize process. Maybe our best bet is just to distract them. Like I said, I don’t have a simple solution—but I think that a lot of any advisor’s value proposition is how successful they are at getting the client to invert their normal thought process and get them to focus on the long term rather than the short term.
Source of Stupid Trick: StupidHumans.org
