Question: Do you tend to buy high and sell low?
Every so often, financial services research firm Dalbar releases statistics comparing stock market returns to the average investor’s actual returns (dependent on when the investor buys and sells). The results of their studies are always the same. The average investor significantly trails the return of the market. Why is this the case? Investors buy when markets are up, when they feel comfortable and have added confidence in the market. They sell when the market is down and declines become too painful. In other words, they buy high and sell low.
In their 2011 study, Dalbar found for the twenty-year period ending on December 31, 2011, the average equity investor’s annualized return was 3.49 percent. Meanwhile, the S&P 500 Index annualized return was 7.81 percent, and thus the common investor underperformed the S&P 500 by 4.32 percent for the past twenty years on an annualized basis.
The problem is that buy-and-hold is analgous to telling overweight people who want to shed some pounds that the solution is easy and simple; they should eat no more than one thousand calories, and they should run for thirty minutes every day. This solution is simple in theory, but very difficult or nearly impossible to execute, as it is in our nature to occasionally deviate or crave variety.
Therefore, let’s concede that one solution to the issue raised in Dalbar’s research is to have a balanced portfolio and to follow a buy-and-hold strategy. You should choose your asset mix and not chase returns. Like Ron Popeil’s classic rotisserie oven informercial slogan, you should “set it and forget it.” Yes, the volatility in the markets may send you on a wild ride, but if you can avoid tinkering with your portfolio and chasing returns, you will be better off down the road.
Knowing the results of the study you might be saying, “All I have to do is select my balanced portfolio and not touch it for many years. Are you telling me that studies prove that this is a winning strategy that will produce above-average returns compared to my peers? It’s a done deal. Sign me up.”
Well, not so fast. Let’s return to the diet analogy from above. Just because the instructions are simple doesn’t mean that the plan is easy to implement over a long period of time. After all, we are human beings, not unemotional androids.
Before we address other headwinds that investors face, such as investment ignorance and the current economic environment, we need to first take a look in the mirror. We need to first recognize the powerful forces that influence human decision making.Whether we decide to implement a theoretically simple game plan like buy-and-hold or more hands-on strategies, good strategies are useless if we cannot stick to them. If we let specific behavioral tendencies get the best of us, we may be no better off than the investors cited in the Dalbar study, who wing it with little discipline or direction.
To avoid falling victim to such tendencies, the first thing we need is awareness.
1. Loss Aversion: Studies like those that Daniel Kahneman discusses in his book Thinking, Fast and Slow indicate that people on average possess a “loss-aversion ratio” of 1.5 to 2.5 times. For example, if you were to put one hundred dollars on the flip side of a coin, most people would request to be paid $150 to $250 to take part in that bet, in return for potentially losing their one hundred dollars. We can conclude from studies like this that the pain of loss is roughly twice as great as the pleasure of gain.
The above example is extremely important because when it comes to investing, you are putting up your hard-earned money. I suggest that portfolios should be tailored to individual investors so that they will be comfortable enough with the regular fluctuations (volatility) so that they won’t be emotionally driven to sell before reaching their goal. As we will soon evaluate, risk tolerance is equivalent to pain threshhold. At what point in a portfolio decline does the emotional pain become too much to bear? When tailoring a portfolio, it is imperative that we honestly self-evaluate and know when this tipping point is reached. Why? Because if you blindly commit to a portfolio (including a sixty‒forty balanced portfolio) and experience some downside volatility past your tipping point, the impulse to sell (and scrap buy-and-hold) may be more powerful than you bargained for.
In order to head off imprudent, emotional financial decisions, better self-assessment and more downside awareness in portfolios need to be incorporated.
Playing defense and being risk aware (risk of loss in portfolio) is more in line with most people’s risk tolerance than playing just offense (since the pain of loss is twice as great).
Read more here:http://www.investopedia.com/university/behavioral_finance/behavioral11.asp#ixzz2KzChDErs.
1. Volatility: An eye-opening statistical trend is that we have now entered an era of dramatically increased levels of volatility, or fluctuations in price.
Therefore, it has become increasingly harder for individuals to fend off their human emotions and rationally invest as volatility has increased. This problem is akin to extreme turbulence during air travel, which is enjoyable to almost no one.
There is no doubt that volatility has been amplified in recent years. This is definitely due in part to technological advances that make it easier to trade, which has led to super computers conducting high-frequency trades (HFTs). What does this mean to the average investor? It means that emotions will be intensified as accounts can fluctuate faster and swing further than before. Increased volatility causes you to push your emotional fear and greed buttons harder and more frequently. This is not conducive to buy-and-hold for emotional investors. Large declines in the price of an investment makes it more difficult for many investors to sit still or stay the course. As we noted, loss aversion is approximately twice as painful as a gain, and volatility increases the odds that an investor will see a decline (even if temporary) that may trigger some emotional pain.
1. Anchoring: Adding to the issues of volatility and loss aversion is the behavioral bias of anchoring. This is the tendency to use an idea or fact as a reference point for future decision making, even though these reference points have no bearing on future judgments or decisions.
For example, suppose an individual purchased a home in 2000 for $300,000. At the peak of the housing market in 2007, the home had appreciated to $750,000, but the individual did not sell. In 2013, the homeowner learned that the current value of the home was $600,000. The individual is now ready to sell his or her home.
If the homeowner views this transaction as a $150,000 loss ($750,000 to $600,000), he or she has thus anchored onto its peak value in 2007, and this might prevent him or her from accepting a fair current market offer. Contrary to anchored beliefs, if the homeowner were to sell the home today, there would be a gain of $300,000, not a loss of $150,000.
Similarly, investors check their statements on a regular basis. In a volatile environment, they might anchor onto a statement that was high one month. They might then react negatively to a subsequent monthly statement that shows a temporary decline in values due to volatility. Self-induced anchoring only clouds one’s judgment, which leads to emotional decisions and imprudent actions. This can lead to poor results. All of this is more likely to occur with increased levels of volatility.
1. Action Bias: Action bias is the opposite of patience. It refers to the need or desire to execute buys and sells within one’s account (not buy-and-hold). As James Montier points out in The Little Book of Behavioral Investing, “Part of the problem for investors is that they expect investing to be exciting, largely thanks to the bubble vision.” The influence of technology, whether it is TV or the Internet, has led to a regularly declining length of holding period for stocks. The average holding period of a stock has fallen from eight years in the 1960s to around five days today (Source: LPL Financial).
People want activity. It makes them feel as though they are being productive and taking action. Montier points out that “the bias to action is especially noteworthy—the urge to act tends to intensify after a loss—a period of poor performance, in portfolio terms.” Therefore, the human urge to sell when the account is down is a huge obstacle to overcome. Dalbar points out that most people cannot overcome this urge. Investors often anchor to higher values that decline due to increased volatility. With declining values, loss aversion, and action bias, investors often sell at the wrong time. All of this makes buy-and-hold very challenging.
When we decide to take action, we have to be careful that we are buying and selling at the right time and for the right reasons. However, we may find that we are simply following the advice of friends or family, or maybe we are reacting to the local news.
When it comes to investments, many people rush into stocks when everyone is getting in, and they do this when markets have already risen. They want to get out when the numbers show that people are getting out, and they do this when markets have already fallen. Unfortunately for the small investor, the average American gets in and out at the wrong time. Pictures speak a thousand words, and the next graph does a great job reinforcing this claim. The chart illustrates the flow of investors’ money into equity (stock) funds and bond funds. The circled areas show how the highest amounts of flows into stock funds were at the peak of the market in 1999. In other words, when stock prices were peaking, so was the individual (the average, small) investors’ optimism and the amount they were investing into stock mutual funds. Conversely, the lowest amount of flows into stock funds was in 2008 and 2009. This occurred at the bottom of the market. This is a graphical way of expressing the phenomena of small investors buying high (1999) when the market is expensive as opposed to buying low (2008, 2009) when the market is inexpensive.
Montier also notes that neuroscientists have studied brain activity when subjects go either with or against the group in various scenarios. He explains that nonconformity and conflicted thinking lit up the amygdala, which is the brain’s center for emotional processing and fear. In addition, studies showed that social exclusion generated brain activity in the anterior cingulated cortex and the insula, both of which are also activated by real physical pain. Montier concludes, “Doing something different from the crowd is the investment equivalent of seeking out social pain. As a contrarian investor, you buy the stocks that everyone else is selling, and you sell the stocks that everyone else is buying. This is social pain. The pyschological results suggest that following such a strategy is like having your arm broken on a regular basis. It’s not fun!”
Contrarion Indicators (Going Against the Herd)
What if you could analyze the consensus of the herd in real time? As the Dalbar study and money flow chart both indicate, average investor often make the wrong decisions as to when to buy and sell. What if we could tap into other investors’ psyches and gauge their level of optimism and pessimism? Would that provide you with valuable input regarding potential action you should be taking (i.e., the opposite or contrarian stance)?
Interestingly enough, many market analysts actually use the current mentality of the herd as a contrarian indicator to help determine when markets are under- or overbought. In other words, when the general consensus (herd mentality) is bullish, it may be time to be bearish and vice versa.
The use of “bull” and “bear” to describe markets comes from the way the animals attack their opponents. A bull thrusts its horns up into the air while a bear swipes its paws down. These actions are metaphors for the movement of a market. If the trend is up, it’s a bull market. If the trend is down, it’s a bear market. ‒Investopedia
The American Association of Investors (AAII) has been tracking investor sentiment for many years, determining whether investors are optimistic, indifferent, or pessimistic on the direction of the stock market. These sentiments are also known as bullish, neutral, and bearish.
On the AAII website (http://www.aaii.com/sentimentsurvey) you will see updated sentiment readings. An example of what you might find will look something like this:
BULLISH: 42.3 percent
NEUTRAL: 29.0 percent
BEARISH: 28.7 percent
Having run these polls since 1987, AAII has gathered a lot of data and is able to analyze with hindsight sentiment readings with specific turning points in the market. What they have found is that these sentiment readings are strong contrarian indicators. When the majority is bullish, a bear market may be around the corner, and when everyone is bearish, a bull market may not be too far behind.
For example, before the famous Black Monday decline of 1987, there were very few investors that were bearish at the time, only 6 percent of those polled. On the flip side, before the market turned from bear to bull in 1990, a very high percentage of those polled were bearish (67 percent) after the Iraqi invasion of Kuwait. The conclusion many have come to is that we, the investors, should become very attentive to when bullish or bearish sentiments reach extremes.
In a research paper for AAII, Wayne A. Thorpe, CFA, drew the following conclusion:
“While little may be gleaned from changes in investor sentiment, identifying extreme levels of positive or negative sentiment appears to offer a glimpse of where the markets may be headed. In looking at the AAII Member Sentiment survey, we found that when sentiment reached overly bullish levels, the markets normally responded negatively in the months that followed. Conversely, the market tended to rise when members became overly bearish.
“While our results here seem to lend validity to the notion that investor sentiment may be used as a contrarian indicator, it would not be wise to base all your investment decisions upon it. Indicators such as this are best used in tandem with others so that you receive confirming signals of potential market movements. Sentiment merely serves as an additional tool when making investment decisions.
“Lastly, even if you do not use sentiment data as an indicator, it is a good idea to be mindful of it. As investors become overly bullish or overly bearish, it is easy to get caught up in the ‘herd mentality.’ However, as we have shown, if you run with the herd, you might get trampled.”
Wayne A. Thorpe highlights that sentiment readings are just one signpost for the potential future directions of the market. An investor should utilize these readings as just one of many tools to evaluate the markets. However, the most interesting aspect of this indicator is that it is contrarian and it goes against what we, the average investing public, would intuitively assume the signals would indicate. The herd is often wrong, and you can use that to your advantage!
Another invaluable contrarian indicator is the Commitments of Traders (COT) reports that are published on a weekly basis. The COT reports show the positions of different traders in various markets, typically at the close of Tuesday’s trading session. The Commodity Futures Trading Commission (CFTC), a US government body with the task of overseeing futures markets, prepares the report. The report’s goal is to create transparency and to fight market manipulation, but it also serves as an an excellent read on the sentiment of the herd. The charts are valuable because they break down the market into three major categories: the commercials, the large speculators, and (as they are labelled) the “nonreportables,” the small individual investors like you and me. Of these three, the two we want to focus on are the commercials, which are known as smart money, and the nonreportables, also known as the dumb money (i.e., the herd, or the public).
The COT data is my favorite contrarian indicator because with retrospection we can look back on various moves in different markets, and we can define specifically who was buying and who was selling at the time. The COT reports provide the clearest example of how the average public investor is suseptible to herd mentality and tends to buy and sell at the wrong time.
Notably, these charts provide indispensable feedback because they show what the herd, or dumb money, is doing. Equally as useful is the fact that these charts report the activity of smart money, or commercial/institutional money. This provides us with a double confirmation on these trades.
The website I utilize for COT analysis is www.COTbase.com. They have provided me with numerous charts that exhibit classic small investor behavior. However, we only need to examine one example to easily grasp the dynamics that are at play. Below, you will find a COT chart for trading information regarding the price movements of the euro, which is a traded currency.
On the upper chart, you will see the market movements of the euro. Below that, you will see the trading activity of the commercials represented by the darker line on the middle chart. Below them, you will see the nonreportables (small investors) on the bottom chart. In looking at these two lines, the key is to identify movements up or down, which indicate their respective purchasing levels for that specific week.
What the graph demonstrates is how the smart money and the dumb money were acting like synchronized swimmers, perfectly reflecting each other’s moves at key turning points. Unfortunately for small investors, they were selling and buying at the wrong times. In early 2011, not only were the commercials buying at an elevated level, but the small investors were selling at a high level (represented by the first circled area, going left to right). This occurred right before the price went up. In May of that year, the opposite happened right before a price decline (represented by the second circled area).
Having to fend off psychological biases and to combat the wiring of the human neurological system is no small task. How do we overcome these tendencies? One option would be to attempt a buy-and-hold strategy. This can be easy if you utilize the ostrich technique of putting your head in the ground by never looking at your statements or turning on CNBC. Another option would be to invest in some sort of less liquid strategy, in which you have little say, control, or access to the funds. This might be a private placement or a hedge fund. A third option would be to utilize proactive tactical strategies that allow you to play both offense and defense in both bull and bear markets (tackling loss aversion). Therefore, you are less prone to the uncomfortable helplessness in major market declines where you see the value of your statement declining while Wall Street instructs you to do nothing (which triggers anchoring and the action bias).
Many of these proactive strategies can also reduce the volatility of your portfolio, thus preventing your pain threshold (risk tolerance) from being reached, causing panic selling. By reducing the opportunity for emotions to dictate your portfolio decisions (characteristics of common investor), your odds of success have dramatically increased.
A Summary of the Buy-and-Hold Strategy:
‒ It works best when implemented at market lows.
‒ It works best if you are not emotional.
‒ It may not work that well in the future (for reasons outlined in subsequent chapters).
Ultimately, we all have three basic choices:
1. No Game Plan (Winging It). I would submit to you that this leads to long-term underperformance that is similar to those studies published by Dalbar.
2. Buy-and-Hold (In-the-Box). For reasons we outline in this chapter, this strategy is harder to implement than you might think. For reasons we outline in chapter four, this may not be the most efficient strategy moving forward.
3. Proactive but Disciplined Game Plan (Outside-the-Box). These are less conventional options that I outline throughout my book.
Timothy P. Higgins, CFP®, ChFC®, Author of Paying for College Without Sacrificing Your Retirement, and Unconventional Investing, Alternative Strategies Beyond Just Stocks & Bonds and Buy & Hold