Insanity

The often quoted definition of insanity is when we do something over and over again expecting different results.  A recent Wall St. Journal article pointed out the three mistakes that investors make over and over again.  After observing human behavior toward financial decisions for over thirty-four years, I was struck by the fact that the list never changes.  Investors keep making bad investment decisions.

First on the list was that investors incorrectly predict their future emotions.  When the market is going our way and we are getting wealthier, we feel like we can weather any storm.  But the reality is that fear is a very strong emotion and we feel the pain of loss twice as much as we enjoy the feeling of getting wealthier.  It is tough to weather market downturns, but the data proves that we should do just that.

Second, investors fail to realize how common volatility is.  The article mentions that the average spread between the best and worst stock returns is 23%.  That is a bracing headwind for someone to has owned only bank CDs.  A correction of 10% loss is very common-about once a year.  We haven’t had a correction for some time, so investors should expect a correction in stocks.  When it happens just keep telling yourself “This is not unexpected; it happens all the time.”

Last on the list is trying to forecast what stocks will do next.  I am puzzled by the fact that investors continue to believe the predictions of ‘experts’ on television, in books and papers.  Nobody can accurately predict the future of anything, much less than the stock market.  “Analyst are terribly good at telling us what has just happened but little use in telling us what is going to happen in the future”.

So what’s the best prescription for Investor Insanity?  Develop a long-term investment plan.  Stay invested.  Rebalance your portfolio.  When we understand this, we can make it through the next correction just fine.