THE IRRATIONAL INVESTOR
DOES THE PRUDENT INVESTOR EXIST ANYWHERE?
THE PRUDENT MAN THEORY
In economics and investing, it was presumed that there was such a thing as "the prudent investor" (called the "prudent man") and that man would make his economic decision rationally and based on fact.
However, a while back, some investment people and some psychologists began to examine the data and much of it conflicted with those theories. (Note that those theories about how people behaved were considered earlier on to be plain and obviously true!)
Fairly early on in my financial advising career, I became aware of, and began to study, "behavioral economics (after obtaining a master's degree in investments and trying to figure out how to produce superior returns). See About. .
WHAT INVESTORS ACTUALLY DO
A prominent example was seen in the fact that at the time the typical investor in the Magellan Fund actually lost money, despite the fact the the fund had a great record of high investment returns!
Basically, simplistically, they got scared when the market went down and even more scared as it continued to go down, so they finally sold (frequently near the bottom and not too far in advance of a dramatic market surge). And then they were so scared that it took awhile to become confident again, but as they saw the market go up, they again made the same mistake, in the opposite direction, presuming that a trend line up or down would continue its direction in the future. They bought after the market had gone up and up and up, probably shortly before the market was to go down. They did the opposite of the traditional wisdom: they bought high and they sold low, which is not a good formula for wealth.
Typically, what this meant was that investment advisors had some value if they kept people from doing what is damaging to themselves. The irony is that the typical smart investment advisor or manager could not really outperform their peers with some consistently superior performance (though that is what they marketed to the world) - so there was not much value there . The true value is that they would be superior to what the investor is likely to (irrationally) do and would at least urge them to stick with the investments.
It's similar to the story, though a cynical one, about the two fellows in the woods who encountered a huge menacing bear. One of the fellows was panicked and out of his mind. The other was relaxed and seemed unconcerned. The first one said to the other "aren't you concerned about what the bear could do to you? And don't you know that the bear can outrun you?" The other fellow said that he knew that, but was unconcerned about his own well-being "because I can outrun you".
WE IRRATIONALLY MISVALUE CERTAIN THINGS
In 2002, Daniel Kahneman and his fellow researcher Amos Tversky won the Nobel Prize In Economics for their "Prospect Theory" about how we humans make irrational decisions when under risk and/or when relying on our intuition. The irony is that both of them were psychologists, not economists or trained investment experts. (Kahneman has a rather thick book which is excellent on this and our other thinking: Thinking, Fast And Slow.
Put simply we as humans value "not losing" more than we value winning. This results in our making decisions that will lose us money instead of coolly evaluating the objective facts and probabilities, much like the mutual fund investors' behavior above (which happened across all the funds).
Basically, stock investors will hold onto their losing stocks because they don't want to recognize a loss (confront their mistakes directly?) but will gladly sell winners. This produces such a bias that the investor experiences lower returns than an objective investor, even with the same intelligence and basic knowledge of investing.
How unsatisfying it is for us ordinary mortals to get an "average" or "conservative" return. We want "more". [Incidentally, the idea of "more", constantly, is a huge source of suffering, according to the Buddha. He was right. Read Suffering And Struggle if you wan to understand that more.]
So we seek to "beat the odds", though we often don't really know what the odds are. Surely an investment manager will not tell you that he cannot get superior returns but can only provide "intelligent diversification" against risks. In a number of studies, as I learned in super detail while studying for my certification as a Certified Investment Management Consultant, it was proven that superior performance of a manager was not sustainable and was originally due to luck. And even superior performance in the past did not inidicate at all that the manager would do more than average in the future. [You might have read in the prospecti that "Past performance does not necessarily indicate future performance."]
Boy, does the typical investor not accept that idea!
Think about it. 500 (or 1,000's) of highly educated specialists in the field analyzing the same extremely available data: how could anyone beat out all of those people? It's not possible. [Except, to some extent, by being more disciplined to follow the rules and go for value, ala Warren Buffett]
Along with greed, the investor has a tendency to undervalue the process of reducing risk by diversifying. Of course, they may espouse the idea of not having all your eggs in one basket (and at risk), but when a super high returning investment pops up they put an inordinately great amount into it. This is more like the philosophy of "invest all your eggs in one basket...and watch the hell out of the basket!"
And then the investor experiences the folly of his "speculation" when tech stocks lose 60% after the tech boom and when real estate began its super crash in 2007 through 2009 after the huge bubble burst, which nobody foresaw fully, except for a few, who happened to guess it right. [The studies about the great predictors of the market who succeeded in one period showed a worse record in the future compared to the average predictor!] [The budget surpluses in the late '90's were attributed to the great skill of those in office at the time. This is a common attribution logic error where people assume that who is in office caused that which occurred at the same time, although any move by one administration most often does not have any effect until several years later. It turns out that a surge in revenues occurred from taxes on the internet and tech stock boom where huge gains could be cashed out causing lots of taxes to be paid! Chalk up another bit of "wrong-cause" thinking (or "non-thinking", nonanalysis).]
DIVERSIFICATION IS LIKE INSURANCE
One of the wisest companies of all time (and one of the most successful, with continued client confidence) was and is Goldman Sachs. Congress stepped in to investigate their role in the great crash of 2009, seemingly seeking to blame someone - attributing naively to the company the powers of the Wizard Of Oz, where it supposedly could control a competitive market from "behind the curtain." They attacked the chief executive for betting against his investors in mortgages.
That is a bit like accusing someone who buys life insurance of betting against themselves, and having a conflict of interest that might cause them to die earlier because of it. That would not be rational.
Goldman Sachs simply recognized their risk, though they could not, as many other experts could not, know the future for sure. But they could know that there was a lot of risk in having a great portion of one's assets in any one area - so it made sense to buy insurance against that risk. AIG was one of the primary insurers against the risk of mortgages going under, but the insurance company ironically did not recognize the risk and the possibility that the risk could be greater than they believed it was! And now the amount of bailout funds that had to go to them approached something like $160 billion - and this was an insurance company, failing to do basic investing lesson #1 - protect against undue, unaffordable mistakes or unforeseable circumstances. [If they had not been bailed out, then they would have not paid out the insurance benefits to other companies, which would, in turn, cause other companies to go bankrupt, and so on, like falling dominoes...]
THE USE OF THE ULTIMATE INSURANCE POLICY
It is interesting that the US government is seen as unduly bailing out "fat cat bankers" (Wall Street) while failing to protect Main Street. But that is a thinking error. In stopping the domino effect that would ruin the financial underpinnings of the economy and cause a much more drastic decline, the economy was protected so that Main Street would not be totally devastated even beyond the Great Crash Of 2009. The bailout, in fact, was of huge benefit to Main Street, though that was obscured in all the panic.
In essence, the federal government paid out "insurance" money to offset the potential risk of everything falling apart. Interestingly, when Bush and Paulson proposed the bailout, Congress voted it down as being unfair or unworkable, but when the market crashed right afterward, Congress immediately approved it.
And the "insurance" money worked!
THE CASE FOR DEWORSIFICATION
I was amused by those who marketed their financial advisory services as focussing in certain key areas so as to produce higher returns without higher risk (by their smartness?), while they derided diversification as being "deworsification". Cute!
Funny, but the same principles seem to work over time every time - and one cannot violate the laws of gravity for very long without suffering the consequences.
The unwise in the investment selling business were either uneducated or were so interested in selling that they violated the "rules".
In the great tech boom, one of the most prevalent sayings was "it's different this time." But those who said, "no, it's not different this time" lost clients or attracted fewer clients while sticking to their principles or "the" principles.
But, it turned out it wasn't "different this time" - economic rules and principles prevailed! And the faith in the good fairy was lost for all time, seemingly, but, alas, only a few years later the same phenonomenon started again, birthing the great real estate boom. (Note that "the great real estate bust" has occurred a number of times before, in the '70's and in the '80's, even a little one in the '90's - but, except for a few wise and patient men who lived through those periods, most people 'forgot" the lessons. ["Those who do not learn from history are doomed to repeat it." Santayana]
ALSO DIVERSIFY OVER "ASSET CLASSES"
The phenomenon of "asset class diversification" came about somewhere around the '80's, especially after the mid 80's real estate crash. Statistically, it was "proven" that you could combine differently acting asset classes in such a way that you could increase returns while reducing the risk at the same time. Beautiful graphs showing this effect were major selling points. And this worked, when graphing past results, but somehow did not work as well in the future.
Surprise! No miracles.
However, since asset class diversification still was worth it in terms of lowering risk somewhat, getting some benefits while getting decent but not outstanding results when compared to the results of whatever the hotter non-diversifying or less diversifying approach was. So people again failed to see the wisdom and started projecting past results into the future, despite the required disclosure printed in every prospectus "Past performance does not guarantee future results." It was true before and it is true today. However, it is very difficult to convince investors of that.
But, I'm sure that you will make better choices, having read this.
You will, won't you?....
(At least get a good advisor...)