In my last column we reviewed how the stock market seemed to generally do well when there were things to worry about, but conversely, embark on declines when most investors are optimistic. It has always perplexed me that investors seem to get the most optimistic or pessimistic at the wrong times, but I recently read a book which has shed some light on the thought process that helps create this cycle.
Stumbling on Happiness by Harvard psychology professor Dr. Dan Gilbert is a great book if you would like to learn more about many aspects of the human thought process and how we interact with others. It does not focus on the realm of investments, but the topics covered have direct application to how we manage our financial affairs, particularly our investments.
Dr. Gilbert reminds us that humans are the only creatures on earth which can imagine the future. This seemingly wonderful gift comes from the evolutionary development of the front portion of our brain, a characteristic unique to our species. However, there's just one small problem.
Since the future hasn't happened yet, the vision we have of the future must be built in our minds using things we do know. Past experiences and, most importantly, our present outlook have great influence over how we envision our future, and even how we perceive what happened in the past. This concept is known as "presentism." I'm sure you can go through some easy exercises on your own to see how this works, but I'll share a few we all can probably relate to. In March of 2009 at the nadir of the financial crisis, there was no good news. We were close to the point where we doubted the ATMs would spit out cash when we put our debit cards in. At that point, our minds were using the very dark news of the moment to create a vision of the future which wasn't pretty.
Thoughts about another Great Depression, 20 percent unemployment, and the stock market going to zero predominated the headlines and cocktail party talk. No one wanted to invest in stocks at the time because our very human thought process was not painting a pretty picture of the future and it was hard to believe that stocks might rise in price again. But, of course, since that time, the level of the stock market has about doubled, illustrating how the pessimism created by presentism led a majority of investors to make a large mistake, in a pattern we've observed time and time again.
At the top of the real estate market in 2005 – 2006, the experience of recent rapid appreciation created a vision of even higher prices, and presentism led some to quit their day jobs to flip houses. It's easily identifiable as silly behavior in hindsight, but in the moment it is so real it is hard to overcome. Avoiding the financial traps created by presentism requires disciplined conscious thought to counteract the overly optimistic or pessimistic views of the time. The most successful investors of all time have done this and trained themselves to buy then others are panicking and to sell when others are buying too aggressively and paying prices too high to justify.
Most individuals don't want to work that hard at the process and I can't blame them. But even the average investor can use some easy tools and methods to help reduce the chance of falling prey to a vision of the future which is not probable to be reality when the future arrives.
Disciplined asset allocation targets in your investment portfolio should help you avoid accumulating too much in one particular type of investment and suffering a bad result when that type of investment goes from boom to bust. I've mentioned the process of "rebalancing" before and it basically involves selling some of what has done well and is now over-weight in the portfolio and buying more of what has done less well and is now under-weight. The procedure is possibly one of the most boring things you can imagine, but studies have shown it to be one of the most important risk control techniques around.
Another technique is to fight the urge to invest new savings as the market moves higher, and accumulate cash instead. Then, when the inevitable more significant market corrections occur, use that cash to buy investments now down to a fraction of their previous prices. You'll need to be able to overcome your fears because you'll be buying when few others want to. But after all, isn't it about buying low and selling high? Of course it is, but our wonderful human brains aren't quite wired to see it that way unless we work at it.
Tom Breiter is president of Breiter Capital Management, Inc., an Anna Maria based investment advisor. He can be reached at 778-1900. Some of the investment concepts highlighted in this column may carry the risk of loss of principal, and investors should determine appropriateness for their personal situation before investing. Visit www.breitercapital.com.