By John Wasik
CHICAGO May 15 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
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
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
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
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.