Are Investors Driven to Trade?

On 07/26/2012, in Investment Strategies, by Jordan Wilson
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I like a general buy and hold philosophy for investing. Find solid, well-diversfied, low-cost investments (i.e., passively managed index funds), acquire by dollar cost averaging, and only adjust holdings to reflect your target asset allocation over time.

But can investors follow this model?

Or are we hard-wired to be traders? 

Are Investors Driven to Trade?

In Why Your Brain is Killing Your Portfolio, the Wall Street Journal considers this question. The article makes some interesting points.

In a study published last month in the Journal of Neuroscience, researchers from California Institute of Technology, New York University and the University of Iowa looked at how people use past rewards to predict future payoffs.

The neuroscientists found that the two control groups tended to make their next bet based largely on how much a slot machine had paid off on the two most recent bets.

Almost as soon as the pattern of payoffs appeared to change, the participants in the control groups dumped one slot machine and jumped to the next. Although they did take longer-term results partly into account, “the healthy subjects appeared to be extrapolating their most recent experience into the future and choosing predominantly on that basis,” says Nathaniel Daw, a neuroscience professor at NYU who helped conduct the study.

In short, people make future decisions largely based on recent actual results.

Smart, not so smart? No idea. But how does this relate to investing?

How This Relates to Investing

Well, if you have ever read a mutual fund prospectus (or managed to read the fine print on a mutual fund television commercial), you will always encounter the phrase, “past performance is no guarantee of future results.” Or something similar.

And that is quite true.

Among the mutual funds that were in the top half of performers in late 2009, according to Standard & Poor’s, only 49% of them still remained in the upper half a year later; a year after that, only 24% were left. That is just about what you would get if you flipped a coin. Trying to find the winners is futile if victory is determined largely by luck.

That means it is difficult for an actively managed mutual fund to consistently outperform its peers. If you are investing based on the latest hot fund manager (and paying higher management fees for that privilege), you may be shifting your money around every year or two (and often incurring transaction costs and triggering tax payable when you do).

That leads back to my buy and hold approach above. But perhaps our brains make it tough to follow this philosophy.

When confronted with the unpredictable, however, the frontopolar cortex refuses to admit defeat. It draws on all your computational abilities to search for patterns in random data.

In the absence of real patterns, it will detect illusory ones. And it will prompt you to act on them.

No wonder so many investors find it hard to muster the willpower to buy and hold a handful of investments for years at a time.

As For Buy and Hold Being Dead

I have covered this extensively. The buy and hold strategy is not dead.

I am not a fan of buying and holding individual stocks forever. Too much can change over time with a single, non-diversified asset.

Nor am I a fan of simply buying a fund and forgetting about it. You still need to monitor the portfolio. Then, as needed, rebalance your portfolio and bring your actual asset allocation back in line with your target.

But as for the general concept of buy and hold being dead, I think not. Stick to low-cost, well-diversified investments and you can hold the core portfolio for a long time. It will only need to be fine tuned as your personal circumstances evolve over time and/or market fluctuations in specific asset classes dictate the need to realign.

Final Thoughts

The article makes another couple of good points.

Most of the folks who say buy and hold is dead don’t talk much about their long-term returns. Instead, they stress how they have done recently, a tactic that for many potential clients has the same irresistible appeal as the last couple of pulls on a slot machine.

So, so true. And people usually talk more about their winners than losers. In my circle, it seems everyone I know made a killing on Apple and no one I know was ever invested in Research in Motion.

So take what all your friends tell you with a grain of salt.

Every investing decision you make should be the result of a deliberate process.

Start by creating a checklist of criteria that every stock or fund must meet before you buy or sell. Make sure you never buy or sell an investment exclusively because its price has gone up or down. In advance, list three reasons having nothing to do with price that would justify buying or selling.

After you sell, track the returns of those investments you sold, after you sold them, to see if they did better than whatever you bought in their place.

Do not get caught up in what the talking heads say on the business channels. Focus on your unique investment objectives and constraints. I think that your asset allocation is more important than your actual investment choices, so get that right first. Then worry about your portfolio holdings.

Do not chase the hot stock or fund manager.

Make investment decisions that are right for you, with the focus on the long-term.

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