Snap decisions can cripple a portfolio
- Article by: ROSS LEVIN
- September 27, 2008 - 9:07 PM
While others may be able to stop eating these candies, I cannot. I force them through my closed lips. Even as I write this, I find myself distracted by the thought of those candy-coated peanuts. While I know this is not logical, I deny myself throughout the year and then gorge intensively.
I was thinking about this as I watched the stock market gyrating violently after the collapse of Lehman Brothers and the takeover of American International Group and the debate about the bailout plan. Just like my love for M&M's causes me to act irrationally, extreme markets cause extreme behavior. Some people are convinced that we are entering another Great Depression and want to sell all of their stocks, while others want to back up the truck and fill it to the brim with cheap investments.
Even though either one of these approaches may, by coincidence, turn out to be right in the short term, these responses really represent the fear and greed that leads to terrible long-term investment decisions.
In their book "Nudge: Improving Decisions About Health, Wealth and Happiness," Profs. Richard Thaler and Cass Sunstein state that a "false assumption is that almost all people, all of the time, make choices that are in their best interest or at the very least are better than the choices that would be made by someone else."
We are constantly confronted with incomplete information and this results in taking shortcuts with our decisionmaking. We may not realize that we are being irrational, because it is so difficult to confront that personal trait.
For example, if you are diversified -- in other words buying baskets of stocks that represent a variety of asset classes (large stocks, small stocks and international stocks) through mutual funds, then the stock market's risk continues to fall as those funds fall.
Good investments keep growing until they become bad investments. Bad investments keep falling until they become good investments. While individual stocks may become worthless, asset classes certainly can't. Yet people rush to buy investments when they have already risen and they sell them after they have fallen. Doesn't that seem irrational?
In investing, one way to combat your self-defeating decisionmaking is through monthly investing into an asset allocation mutual fund. Your focus is simply on sending in the money, not on how it is invested. Each month you are buying more shares. And the best news is that you buy the most shares when the investments have fallen. If you choose a low-cost, market-performing investment and don't plan to spend the money for several years, you will almost assuredly have more than you contributed.
The key to success over time is being incremental in your decisions. No one bats 1.000 in this business, so if you are constantly making big bets, you will inevitably strike out. That's why if you are not owning a mutual fund that rebalances its allocation for you, then you need to do it yourself. I have automatic rebalancing on my 401(k). This means that every quarter, money is being directed toward those asset classes that have underperformed and is taken from those that have overperformed.
Thaler and Sunstein point out our "two kinds of thinking, one that is intuitive and automatic, and another that is reflective and rational." This is the left-brain, right-brain discussion.
Both are essential for how we live. We may call on one style more than the other, but each of us rely on both.
This is very important when you want to hire a financial professional. Not only is it necessary to understand the offering as well as the skills of a person that you are choosing to hire, but you should also have a personal connection to them. It may seem that technical expertise is enough in the beginning, but that is only if things go exactly as planned. Unfortunately, things never go exactly as planned. If you are responding emotionally to a particular situation or event, you will probably be frustrated by the professional who is only trying to connect with you rationally.
Does this sound like a recent conversation you have had with your partner or children -- or your investment adviser?
While I am forced to avoid M&Ms, we shouldn't avoid financial decisions in the same way. Follow your plan, rebalance accordingly and reach for the veggies.
Spend your life wisely.
Ross Levin is the founding principal of Accredited Investors Inc. in Edina. He is a certified financial planner and author of "The Wealth Management Index." His Gains & Losses column appears on the fourth Sunday of each month. His e-mail is firstname.lastname@example.org.
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