|
|
|
|
 |
|
Protecting Investors from Themselves
A Leading Behavioral Economist Discusses Why Investors Often Act Against Their Best Interests
Confronted by extraordinary trends or events, investors are often seduced into making decisions that rival their predefined long-term plans. Consider how investors reacted to the inflation and bursting of the tech balloon.
"Many investors did exactly the opposite of what they should have done," says Brad Lawson, Senior Research Analyst at Russell. "Just as many investors acted against their best interests when the markets were soaring in the '90s."
The study of behavioral economics sheds light on this often counterproductive behavior.
Our Irrational Nature
Classic economists tend to characterize economic agents as highly rational and unemotional. But markets are defined by interactions between people. Behavioral economics, an academic discipline begun nearly two decades ago, examines the psychological perspective of how people interact with market forces.
According to Lawson, behavioral economics applies to every level of investing. And the findings can be disturbing. "Investors are not as rational or objective as they think they are," Lawson asserts. "In failing to understand our weaknesses, we often hurt ourselves."
Russell's response to the "human factor" in investing? "We've long been proponents of developing a long-term, diversified investment plan," Lawson said. "In fact, we developed our multi-manager approach to help keep those plans on target. That way, investors don't have to think about making frequent, and often stressful, decisions — and risk making regrettable mistakes."
The Study of Investor Behavior
Dr. Richard Thaler is a Principal of Fuller & Thaler Asset Management, San Mateo, California. A Russell money manager, Fuller & Thaler focuses on micro- to medium-cap equities. The firm combines fundamental research with insights from behavioral finance to gain a competitive edge over the market. Dr. Thaler is also the Robert P. Gwinn Professor of Behavioral Science and Economics at the Graduate School of Business, University of Chicago.
Using a variety of research methods, including laboratory experiments, Dr. Thaler and other behavioral economists gain objective insights into investors' biases and the negative actions they produce. Interestingly, Dr. Thaler points out, poor decision making is not more common during volatile market activity. "There's no evidence that we're less rational during volatile times. Rather, those periods simply present more opportunities to act foolishly."
Five Common Mistakes
So what common pitfalls should investors avoid? Dr. Thaler cites:
| |
- Overconfidence. This may be the biggest problem of all. "Investors overrate their ability to select winning stocks or mutual funds," Dr. Thaler divulges. "But evidence suggests that individuals don't do better than chance." The Internet exacerbates the problem. By providing easy access to information, the Internet creates an illusion that investors see information not available to others and thus gain an advantage. The truth is that everyone has access to this data. Moreover, once this data reaches the Internet, it's already dated and behind what professionals likely have already received.
- Loss aversion. Research indicates that a loss causes about twice as much pain as a gain causes pleasure. During periods of market volatility, investors experience the sense of loss more acutely. Moreover, they fail to sell when stocks are heading down, refusing to acknowledge a mistake.
- Return chasing. When the market goes up, too many investors delay buying — often until just the wrong time when stock prices have peaked and are about to head down. "There's lots of evidence that people think what goes up will always go up," Dr. Thaler said. Worse yet, many investors have developed an aversion to equities that has kept them from getting back into the stock market at levels far below those of the late '90s and early 2000. "I'm not a market timer, but I find stocks way more attractive now than two years ago. You've got to like the Nasdaq better at 1,400-plus than at 5,000."
- Investing too much in an employer. "This is starting to change," Dr. Thaler said, "but not quickly enough." People learned the wrong lesson from Enron. "They think they shouldn't invest in their employer if it's cooking the books. But the right lesson is, don't put the majority of your assets in any one stock — especially not the company you work for." Hedging risk is smart.
- Refusal to sell winners. How many investors bemoan the profits they could have had — if they'd sold in time? "Diversification is the key," says Dr. Thaler. "If a stock or fund has gone way up and become a big part of a portfolio, trim it back." Maintaining an asset allocation model offers the discipline required. "Learn from professionals. Portfolio managers have rules limiting the position of any stock or sector."
|
A Plan as Self-Defense
An antidote to behavioral mistakes could come in the form of a well-defined, long-term investment policy. "A good way to ensure that you stick to it, especially when the markets become uncertain, is to write it down," Lawson says. "This helps you do the right thing, which is often the exact opposite of what your gut tells you, when the market is uncertain."
It's the same philosophy used by Russell's world-class manager research group to evaluate and select managers for Russell's investment-products. "(Managers) must be as objective as they are smart, willing to acknowledge mistakes and move on," Lawson said. "Being honest with yourself is critically important."
Consistent with long-term planning, Lawson cites Russell's diversified approach which spreads risk across asset classes, then adds depth to each with a multi-manager combination. "Our principles of diversification ensure that some of our managers will act defensively to build profitability over the long run. This enables us to avoid sudden, irrational reactions to short-term movements in the market."
Investors can do the right thing in spite of the pressures created by market volatility, Lawson emphasizes. "We can protect ourselves from ourselves when we're honest about our nature and plan accordingly."
Date of first use: December 18, 2002.
Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.
|
|
|
| |
Other Related ARTICLES |
|
|
|
Products and services described on these websites are intended for Canadian residents only. Information on these sites should not be considered a solicitation to buy or an offer to sell a security to any person. Persons outside Canada may find more information about products and services available within their jurisdictions by going to Russell's worldwide site, http://www.russell.com.
Legal Information Privacy Policy
Required Sales Disclosure
© Russell Investments Canada Limited 2009. All Rights Reserved.
|
