COLUMN-Four ways to avoid bad decisions during a bull run
By John Wasik
CHICAGO May 15 (Reuters) - Is the Dow's movement above 15,000 or the record close of the S&P 500 Index last week a buy signal? They may not mean anything, but most market watchers believe the rise is talismanic.
Despite the lure of recent market gains, there's often no pattern to investment results. To avoid seeing patterns where there may be none - and acting irrationally - we often need to short-circuit our instincts and think counter-intuitively.
A go-slow approach that avoids trading on market timing can often avert losses. Here are some behavioral biases and ways to prevent bad decisions:
1. Don't time jumps in and out of the market.
Trading decisions typically are expensive and eat into your total return.
A study released late last year by the Gerstein Fisher research center found that the S&P 500 posted a 6.66 percent annualized return from Jan. 1, 1996, through Dec. 31, 2010. After trading, inflation, fund expenses and taxes, however, individuals reaped a miserable 1 percent return. Investors paid a steep penalty for market timing.
2. Buy and hold works.
We tend to be overconfident in our ability to predict the future.
Let's say you held a basket of small-company stocks from 1993 through last year. You would have reaped an 11 percent compound annual return, according to Ibbotson Associates. If you were in large stocks, your gain would have been about 8 percent on average annually if you held your position for 20 years through 2011, according to Dalbar, a Boston-based financial research firm.
Most investors didn't stay still. They lagged the S&P 500 index by more than four percentage points. Keep in mind that this period included more than two recessions and two major market sell-offs.
Trading can be expensive, too, even when you think you're being cautious. Let's look at 2011, a particularly volatile year. Stock-market investors studied by Dalbar lost 5.73 percent when they cashed out at the sign of trouble. Simply holding the S&P 500 would have netted them a slight gain.
3. Immediate past results don't predict future returns.
When a market reaches new heights, investors fall prey to what behavioral economists call "hindsight bias."
We tend to overestimate the possibility that immediate past performance will continue. As a result, the herd flowing into the market often gets in at the peak, just before a decline.
Burned investors tend to head in the wrong direction. Look at two years of the current bull market - 2010 and 2011 - when it would have been a good time to get in on the early stages of the record-setting ascent following the financial crash.
Some $370 billion poured into bond mutual funds during those years, according to the Investment Company Institute, compared to an outflow of nearly $140 billion from stock funds.
Of course, there's no way to predict how long a rally or downturn will last. That's why it's best to look to your own goals, not major market turns, to anchor your decisions.
4. My stocks will bounce back.
The hardest thing to do emotionally is to take a loss and move on. A notable research paper by Terrance Odean of the University of California, Berkeley, demonstrated that the aversion to dumping losers is common and costly. He found that investors could have earned a 4.4 percent better return if they had sold them while holding onto winners.
Often we buy stocks or funds because we're sentimentally connected to them or simply a lot of other people are buying them. If millions of others like something, it has to be good, right? Wrong - and it doesn't mean they'll be good investments in the future, either.
That's why it's important to pay attention to the purchase price and where the stock is headed. Compare price/earnings ratios against similar stocks. Are they overpriced? What's the direction of the company and competition?
Most of all, get over what Daniel Kahneman, Nobel Prize winner in economics and author of the best-selling book "Thinking Fast and Slow," calls the "delusion of control" that many investors possess when viewing the market. The only things within your power are how much you pay for your investments, how often you put money to work and how much you save.