Make yourselves sheep and the wolves will eat you.” - Benjamin Franklin
I wrote the below newsletter back in October of 2017. My conclusion at the time was investors tend to be their own worst enemies. Nothing has changed.
Today, I believe markets (particularly stocks) are at the beginning of a back and forth transition right now, which will more than likely end up in a modest risk-off period. Imbalances need to be worked off and new clearing prices discovered.
In the short run economic fundamentals such as, valuations, profits and growth seem to matter less than psychology and emotions. However, over longer periods of time fundamentals do matter and this is where financial markets go through periods of mean reversion.
When will this happen…. no idea, but the risk/reward profile of financial markets today points to a larger allocation towards safety such as T-bills, U.S. Treasury Notes and Bonds at the expense of equity and credit sensitive instruments.
Working with an experienced financial adviser/investment manager helps to take our built-in emotions and biases out of the picture and is especially valuable during market turning points or periods of uncertainty and distress.
Ask a professional money manager, what are the greatest forces driving investor behavior and you will likely receive the following response – “Greed and Fear.” Broadly speaking this is true. As a group, investors tend to load up on risk when the investment environment appears benign in an attempt to capture a bigger share of the spoils. Conversely, investors predictably run for the hills as word of danger spreads. Separating the news from the noise is almost always easier said than done.
Closely related but much less appreciated is the concept commonly referred to as the “Fear of Missing Out” or “FOMO” for short. No one likes to miss out on a good thing, especially when they see their friends, neighbors or rivals cashing in. Many investors will not tolerate underperforming their peers in bull markets. However, as markets decline and losses mount the same comparisons seem to go by the wayside. Rarely does one brag about losing less money than the next guy. But maybe they should, as limiting losses in down markets is the key to long term growth.
Much of the above feelings may be driven by concerns about relative wealth, or how much you have compared to those in your peer group. This theory was explored in a 2007 study, “Relative Wealth Concerns and Financial Bubbles,” by Peter DeMarzo and Ilan Kremer of Stanford University and Ron Kaniel of Duke University.
The authors found that even when investors believe prices are high relative to fundamentals, they often remain fully invested due to a fear of missing out on a further extension of valuations. “Relative wealth concerns help support the existence of financial bubbles by increasing the risk of trading against the crowd.” Investors who strive to keep up with the “Joneses” may be adding to their anxiety while ignoring seemingly obvious risks.
Since 1994, the Dalbar Group has studied the effects of investor decisions to buy and sell mutual funds over various time horizons. The results consistently show that individual investors earn on average much less than mutual fund performance reports would suggest. The chart below, courtesy of Richard Bernstein Advisors, shows the annual performance of the average investor over the past twenty years has failed to exceed the minimal returns on cash as measured by 3-month U.S. Treasury bills. There are a few factors related to this historical underperformance but mistiming investment decisions (investor behavior) had the greatest effect on the results (see link to audio interview here).
As a group, individual investors are often late to the party – they tend to buy and sell at the wrong time. Numerous studies have shown that trying to time financial markets on a short-term basis is an exercise in futility. On the other hand, investing with a long time horizon has a high probability of success – after all, investors usually demand to be compensated for tying up capital and bearing risk.
My advice for investors is to work with a professional. When volatility is low and markets are rising, investing mistakes are easily washed away or swept under the rug. Given time, these trends will reverse and investor anxiety will return. In this case, the mistakes of the past are doomed to be repeated. Securing the counsel of an investment manager/advisor can make the difference between being the average investor described above or achieving one’s goals.
Justin Kobe, CFA
Founder, Portfolio Manager & Adviser
Pacificus Capital Management
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Advisory services through Cambridge Investment Research Advisors, Inc., a Registered Investment Adviser. Securities offered through Registered Representatives of Cambridge Investment Research, Inc., a broker-dealer, member FINRA/SIPC. Cambridge and Pacificus Capital Management are not affiliated. Material discussed is meant for general illustration and/or informational purposes only, and it is not to be construed as investment, tax, or legal advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon when coordinated with individual professional advice. These are the opinions of Justin Kobe and not necessarily those of Cambridge Investment Research, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Investing in the bond market is subject to risks, including market, interest rate, issuer credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies is impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counter-party capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Diversification and asset allocation strategies do not assure profit or protect against loss.