Cutting through the noise: a logical approach to an emotional stock market

 

“The investor’s chief problem – and even his worst enemy – is likely himself.”
 – Benjamin Graham, The Intelligent Investor

When it comes to investing, everyone is an expert – or so it would seem.  Whether it’s on TV, in the newspaper, on the Internet or around the water cooler, everyone has an opinion on “the market.”  The trouble is, many of these ideas are in conflict with one another, and that can make it awfully hard to know what to do with your own investments.  TV pundits tout the growth of China, brokerage firms regularly revise their “buy” and “sell” ratings, magazine covers advertise “137 ways to get rich,”[1] and mutual fund companies talk up the merits of their latest strategies.

Studies of investor behavior demonstrate that this daily bombardment of market news takes a toll, causing us to make worse financial decisions than we otherwise would.  In 1987, for example, the psychologist Paul Andreassen ran a thought-provoking experiment to assess how news reports affected investors’ trading decisions.  What he found was that people who received no news about the companies held in their portfolios did better than those who received frequent news updates.[2]  In other words, no information at all is actually preferable to too much information.  The reason: news makes us act, and often our actions are detrimental to the long-term growth of our investments.

This isn’t just academic.  Multiple studies of individuals’ real world results prove that nonstop exposure to financial news causes us to act impulsively, and that this imposes significant costs.[3]  In a paper titled “Trading Is Hazardous to Your Wealth,” University of California researchers Brad Barber and Terrance Odean demonstrated that individual investors consistently underperform broad market indices.[4]  Why is this the case?  In large part, it is because many investors trade too frequently in an ongoing, but ultimately fruitless, pursuit of the next hot idea.  In fact, in their study, Barber and Odean found a direct relationship between investors’ trading activity and their returns.  The most active traders realized the worst performance, and the least active did the best.

How can you do better with your own investments?  Below are three suggestions to help you navigate your own course in a way that sidesteps these pitfalls:

First, recognize that investment decisions are specific to every individual, so your starting point needs to be a personalized investment plan that is designed around your own specific goals.  When you have this in place, it will serve as your touchstone and a reminder that you shouldn’t feel the need to rethink your strategy every time the market moves or a TV pundit makes a recommendation.  No one on TV or in a magazine can tell you what is best for you.

Second, recognize that there is no one “right” answer or “best” strategy when it comes to investing.  Sometimes growth stocks will be rallying, and at other times it will be value, or small-cap or International.  In some periods Internet stocks will appear unstoppable, and in other periods energy stocks will be all over the headlines.  Research has shown, however, that individual investors are very poor at predicting the market’s future movements, [5] so the best approach for most people is to create a broadly diversified portfolio and to be disciplined in maintaining that diversification over time.

Finally, when crises come – as they inevitably do – you want to stay calm.  Intuition suggests, and the data prove, that investors are most likely to make costly mistakes when the market is in turmoil. [6]  As long as you understand what you own, and the role that each investment plays as part of your overall plan, it should be easier to sit tight through periods of market turmoil.  Even though we often feel compelled to do something when we see the value of our investments decline, often the better decision is to avoid making any rash decisions.  As the psychologist Andreassen pointed out, “when a news story breaks, investors should ask themselves whether anything, other than the price, has really changed.”  If the market is, in fact, just being irrational, and nothing has fundamentally changed, then just take a deep breath and remember that there is no such thing as a loss until you actually sell something.

Warren Buffett once said, “Wall Street makes its money from activity; you make your money from inactivity.”[7]  The evidence suggests that he is right.  When your investment strategy is designed around your own personal needs and goals, you’ll have a far easier time sticking with it regardless of what the market is doing or what the headlines are saying.  Not only will this help you sleep at night, but this research indicates that your portfolio will be better off as well.

[1] Forbes, June 29, 2015.

[2] Andreassen, Paul B., “On the Social Psychology of the Stock Market: Aggregate Attributional Effects and the Regressiveness of Prediction,” Journal of Personality and Social Psychology, Vol. 53, No. 3 (1987), pp. 490-496.

[3] Barber, Brad M. and Terrance Odean, “All That Glitters: The Effect of Attention and News on the Buying Behavior of Individual Investors,” Review of Financial Studies, Vol. 21, No. 2 (April 2008), pp. 785-818.

[4] Barber, Brad M. and Terrance Odean, “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors,” The Journal of Finance, Vol. 55, No. 2 (April 2000), pp. 773-806.

[5] Barber, Brad M. and Terrance Odean, “The Behavior of Individual Investors,” September 2011.  http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1872211 (Retrieved December 1, 2015).

[6] DALBAR Inc., “Quantitative Analysis of Investor Behavior, 2015 Edition,” page 7.

[7] Andrews, David, Editor, The Oracle Speaks: Warren Buffett in His Own Words, Agate Publishing, 2012, page 28.