Overcoming Your Wealth Destroying Instincts and Becoming a Better Investor 1 - Following the Herd

I thought that in the aftermath of the “Great Recession” that it would be beneficial to use the blog to discuss the numerous errors that investors tend to make that are not unique to who we are but rather to what we are. I have been an investment advisor and financial planner for almost 25 years. When you have spent that length of time on the other side of the desk from thousands of individual investors you realize that some errors in financial management are so common that their basis seems to be rooted in human nature rather than anything unique to any individual. Because of my background as a biologist, I tend to look for physical explanations for human behaviors and I feel very strongly that a lot of what we do, particularly how we react to stressful situations is rooted in our evolutionary biology. The fact is that we have been something that can be identified as human for about 2 million years or so and we have only been investors for about 2000. So 99.9% of our evolutionary development has been devoted to developing the survival skills of a hunter/gatherer rather than investing skills.

It has long been noted that we tend to exhibit a herd mentality when it comes to investing. The most glaring example is the stock market where investors habitually crowd in when stocks are doing well and flee in droves whenever the market corrects. One of my greatest frustrations as a financial advisor is that, while investors are more educated that ever and have access to more and better information than ever, the “herding” problem appears to be getting ever worse as evidenced by the increasing frequency of financial bubbles.

An interesting proof of this is the data that mutual fund research firm Morningstar gathers to produce a calculation of the “effective return” that the average investor actually received in any given mutual fund due to money moving in and out of the fund rather than the actual returns earned by the fund manager. Keep in mind that this has nothing whatsoever to do with fees, as all results were net of fees. This discrepancy in the return the average investor received is due solely to investor behavior.

An interesting and illustrative example is the CGM Focus Fund run by famed manager Ken Heebner. A recent article in the Wall Street Journal notes that CGM Fund was the top performing mutual fund for the prior ten year time period, posting an annualized return of 11% per year. However the Morningstar data revealed that the average investor in the fund actually lost an average of 10% per year during that same time period! No, you didn’t misread that, a loss of 10% annualized. What happened? Is Mr. Heebner guilty of a misrepresentation or worse yet a fraud? Absolutely not, Mr. Heebner and his staff are very good at what they do and did, in fact, posted those excellent returns. Rather, the problem lies with the behavior of the investors themselves.

Mr. Heebner is, as most investment professionals know, a growth manager and is extremely aggressive with this particular fund. Investing with him in CGM Focus can be very rewarding but requires a cast iron stomach and a great deal of patience as this fund has very good long term performance relevant to its peers but is prone to wide swings in value. Investors who invested in the fund at the beginning of that ten year period and stayed invested did indeed see their money grow at an 11% annualized rate. But during this period the fund fluctuated so much in value that many of its investors were alternately so overly optimistic that they ignored its well publicized risks or were panicked into selling during the downswings. One example, in 2007 CGM Focus produced an astounding 80% return and investors crowded in flooding the fund with $2.6 Billion in late 2007 and early 2008 just in time to catch its breathtaking 48% drop in 2008 when they withdrew $1.2 Billion. It seems to me that investors have misused this fund. It should be considered for the aggressive growth allocation in a broadly diversified portfolio not as a market timing vehicle.

All of the academic literature that I have seen indicates that small individual investors underperform the market rather dramatically. This is a perfect example of why. Our instincts tell us to follow our fellow humans. Why? Simply because for 99.9% of our existence as a species if one hung with the herd he/she didn’t get eaten by the saber toothed tiger or stepped on by a wooly mammoth. If one went off on one’s own, he/she did get eaten or stomped on. Evolution, in this case, has produced a very powerful instinct. Unfortunately, as evidenced by the prior example it’s an instinct that can cause us a great deal of harm in today’s investment environment. In the words of Walt Kelly’s Pogo, “We have met the enemy and he is us”.

So how can you avoid this costly tendency? First of all do not chase returns. Realize that by the time you hear your barber, your co-worker or your great Uncle Joe talking about how great any investment opportunity is, it’s too late. What you should do is design a diversified portfolio that suits your risk tolerance and time horizon (an experienced, fee-only investment advisor can help with this) and develop a funding plan. Then, and this is the hard part, stick with your plan no matter what the market throws at you. Sound investment practice requires both patience and courage. It is vital that you rebalance your portfolio(s) at least once a year to maintain your target asset allocations. Also recognize that all of the variables involved in any investment plan (risk tolerance, return requirement, funding requirement) change over time, so sit down with your investment professional and revisit your plan at least once a year.