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Market Perspective:
Succeeding as Investors In Spite of Ourselves
 By Ernie Ankrim, Ph.D.
Chief Investment Strategist
Global Leaders in Multi-Manager Investing
April 25, 2003
Human beings are wonderfully suited for many things. We've developed language, conquered gravity and made the most of our opposable thumbs and infinite imaginations. What we're not terribly good at, though, is overcoming our own worst impulses — particularly as investors.
Are we wired for failure?
I'm beginning to think that the way human beings are psychologically made up makes it difficult for us to pursue an optimal investment strategy. In other words, we're somehow "wired" to be more susceptible to behavior that produces less-than-great results.
This theory actually derives from work done by neuropsychologists. These scientists studied the behavior of both human and non-human subjects when faced with random payoffs. After observing a series of lights, human subjects were asked to guess whether the light would next flash red or green. Non-human subjects, typically rats or pigeons, simply hit a red or green button; pressing red would deliver food and pressing green would administer a mild shock.
The scientists noticed that the subjects engaged in two very different types of behavior; the rats and pigeons employed a "maximization" strategy while the human subjects preferred a "matching" strategy.
Maximizing vs. Matching
What was the difference? The maximizing rats gave up recognizing randomness; they simply picked the color that came up most frequently (and offered the best payoff).
Matchers, on the other hand, tried to match their behavior to the random outcomes. A subject observing that red came up eight times out of 10 would guess red 80% of the time and green just 20% of the time.
In theory, this matching strategy holds the possibility of always being correct; if the subjects' guesses exactly match the random outcomes, they could conceivably get 100% right. In practice, though, the mathematics don't work out that way. If human subjects are right 80% of the time on red and 20% of the time on green, their overall percentage of being correct is actually only 68%. However, rats and pigeons, "guessing" just the red button, would be correct 80% of the time.
So, according to this study, humans actually do much worse than rats or pigeons when it comes to predicting random outcomes.
Our need to be right makes us wrong
The psychologists hypothesized that rats and pigeons choose a more optimal strategy than we oh-so-smart humans because they have no desire to be precisely correct. Instead, the animals recognize that they're going to be wrong some percentage of the time and would like to minimize the error (and risk of mild shocking). Humans, on the other hand, aspire to be perfectly correct, and as a result, we're wrong a higher proportion of the time.
Now what does this have to do with investing? The random outcomes tested in these studies are much like the random day-to-day variations we see in the financial markets. Our need to find patterns in complete randomness actually causes us to do much poorer than if we — like the rats — simply pursued the best long-term strategy no matter how much it hurt in the short run.
Investors are great at predicting the past
Cash flows into mutual funds are a good example of how we condition our behavior based on recent happenings. Looking at cash flow statistics over the past 18 years, I found that money tends to flow into stock funds in the 12 months after stocks have performed well and to flow into bond funds in the 12 months after stocks have done poorly.
Yet while money followed past performance, future performance didn't necessarily follow the money. When I analyzed actual market behavior for this same period, I found that there was virtually no correlation to investors' purchasing patterns. In fact, in the period after extensive cash flows had gone to stock funds, bond funds actually outperformed, and vice versa. Investors turn out to be great at predicting the past, but we're not terribly good at guessing what's going to happen in the future.
And we're getting more myopic
Unfortunately, recent evidence shows that we're becoming even more short-sighted than ever before. In 1960, investors held stocks for an average of eight years. By 1980, the average holding period fell to three years and today, investors hold stocks for an average of just 11 months. The conclusion I draw from this is that investors are getting less like rats and more like ourselves every day — and that's not encouraging.
So what can we do to improve our chances of investment success? I encourage you to ignore your very human gut instincts and behave more like the rat or pigeon: Determine a plan based on your objectives and risk tolerance and stick with it. This is one reason why consulting a financial professional can be so valuable. If they can assist you in sticking with your strategy, rather than chasing after the next random payoff, your investment behavior might be elevated to that of a rat or pigeon.
It's a humbling realization that, by giving up the chance to be perfectly correct, we might actually improve our investment success to the level of these low creatures. But then humility has always been a valuable trait. Maybe in investing this is truer than we ever knew.
Date of first use: April 28, 2003
This is a publication of Russell Investments Canada Limited. It should not be construed as investment, legal, or tax advice. The contents are intended for general information purposes only, and you are urged to consult your own investment, legal, or tax advisor concerning your own situation and any specific investment questions you may have.
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