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When It’s Wrong It Feels So Right |
Here’s Why He Won’t Squeeze the Trigger
“Did you see how much the market was off
today?” Tim asked as I was enjoying a JFR Super Toro Maduro at Joe’s
cigar bar.
“Yup. Maybe the most anticipated correction in
the last 10 years is finally materializing,” I replied.
“I sure hope so,” said Tim. “I’ve got a lot of
dry powder sitting in cash and I’m ready to make my move.”
“How long have you been in cash?” I asked.
“Since February,” said Tim.
“When do you plan on getting in?” I asked.
“Once the market is off 10 percent from its
recent high, I’m putting my finger on the trigger. Then I’m going to
keep an eye on things and make my move when it feels right.”
Loss Aversion
“Good luck with that. And let me know when you
make your move,” I said, turning my attention back to my cigar.
I truly hope Tim makes the right call and gets
in at the right time. But I doubt that he will. Most investors don’t.
The fact that Tim went to cash in February is telling.
He rode the market down from October 2007,
waiting for a rally that never came. He finally threw in the towel in
February, just as the market was close to a bottom.
Why didn’t Tim get out of the market sooner?
Simple. Loss aversion. Behavioral scientists have demonstrated many
times that people will go to extraordinary lengths to avoid
feelings of regret. How far will they go?
Mr. A or Mr. B?
Consider this study conducted by behavioral
economist Richard Thaler …
Researchers presented subjects with two
scenarios:
* Mr. A is waiting in line at a movie theater.
He gets to the ticket window and is told that, as their 100,000th
customer, he has just won $100.
* Mr. B is waiting at a different theater. The
man in front of him wins $1,000 for being their millionth customer. Mr.
B wins $150 for being customer number 1 million and 1.
“Who would you rather be,” the study
participants were then asked, “Mr. A (who won $100) or Mr. B (who won
$150)?”
Me? I’d rather be Mr. B. I’ll take $150 over
$100 every time. Amazingly, twice as many people said they would prefer
to be Mr. A!
Why?
Because Mr. B “lost” $850 just for arriving at
the theater a bit late. So they would forgo the $50 difference to feel
like a winner instead of a loser.
Don’t look for logic here. It’s pure emotion.
When It’s Wrong It Feels Right
So why did Tim ride the market almost all the
way to the bottom? Emotionally, he couldn’t take on a loss until he was
overcome with fear. Logic played no part in his bailout decision in
February.
And my guess is logic will play no part in his
reentry scheme.
Let’s say the Dow drops to 9000 – which is
beyond Tim’s 10 percent threshold. Will Tim invest then? I doubt it.
He’ll worry that the market will head lower, and loss aversion will
prevent him from making a move. Should the market actually head lower,
the cycle will repeat itself.
In all likelihood, Tim will commit his money
to the market when all the economic forecasts are good and it feels
safe. That’s called a market top.
Remember 1999? Arguably the worst year to
invest in recent memory. Yet investors were falling all over themselves
to get a piece of the action. When it’s wrong, it feels right.
Emotional Rescue
The fact is, buying high and selling low feels
natural for most people. As human beings, we are hardwired this way for
reasons best left to another posting. But you have to override your
instincts and let logic, not emotions, dictate your actions.
Commit one-twelfth of your cash to equities
and pick a day to invest that money this month. Invest another
one-twelfth of your cash on that same day every month for the next 11
months – regardless of what’s going on in the markets.
This is called “dollar cost averaging.” Here
is an oversimplified illustration of how it works:
Let’s say you commit $1,000 a month to an
investment in XYZ corp. The stock is trading at $5 a share in month one,
so you buy 200 shares. The next month, the stock trades for $10 a share,
so you buy 100 shares. In the third month, the stock falls to $7.50 a
share, so you buy 133 shares.
Got it?
Okay. So now you have invested $3,000 and own
433 shares of XYZ. At $7.50 a share, your investment is currently worth
$3,247. You’ve made 8.25 percent.
(Can you see how investing this way takes your
emotions out of the equation?)
Where to Invest
I’m sorry if I sound like a broken record, but
my advice remains the same:
* Sell your dogs and move into quality issues.
* Favor stocks with healthy (and growing) dividends.
* Add high-quality corporate bonds to your asset mix.
* Diversify overseas.
* Buy gold.
If you think this is easier said than done,
then you need advice you can trust. And you can get it from
Sound Profits, IDE’s investment trade service which tells you
how to invest both safely and profitably. It’s debuting next month.
Invest Safely,
Bob Irish
Investment Director
Investor's Daily Edge
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