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Wednesday, May 20, 2009

Good Advice: Keep Emotions Out of Investing

James B Stewart of the WSJ offers real world observations on the tendency of investors to let their emotions dictate their actions and as a consequence often chase the market in reaction to short term moves.

Fear and Greed: 2 Things You Shouldn't Invest In

.... From their lows on March 9, stocks have registered some of their steepest gains since the 1930s, which takes us back to the Depression for comparisons.

So why aren't more investors celebrating?

True, stocks are still down 40% from their highs of 2007, so most people don't feel nearly as wealthy as they did back then, even after the historic rally. But I sense that isn't the reason that so many investors are feeling so cranky. It's because they missed it.

If fear and greed are the defining emotions of investing, then there's nothing like a missed opportunity to bring out the greed. Many usually sober people bought into the doomsday scenarios so prevalent in January and February. They weren't just unwilling to bet on stocks recovering any time soon; they actually bet against the market -- piling into safe-haven U.S. Treasurys, moving heavily into cash, and even, in extreme cases, shorting the market. And then they sat back to wait for their actions to be vindicated.

So far, they have waited in vain. As stocks have soared, those super-safe Treasurys have slumped, dropping in value about 20% since the first of the year as interest rates have risen. No wonder these people are feeling testy.

You rarely hear these people bemoaning their fate. That's why I was impressed by a Wall Street Journal article this week in which several investors candidly acknowledged that they couldn't take the pain of a plunging stock market and had bailed out, in some cases at or near the market bottom in March. I appreciate their honesty, and I'm sure their sentiments were shared by many others less forthcoming.

There is no reason to be ashamed of a decision simply because the market moves against you. No one is right all the time, and there's no way to predict where markets are headed, which is why I resolutely avoid such forecasts. But these are important learning experiences that should help people untangle their emotions from rational investing.

In my experience, investment decisions based on emotion, however satisfying in the moment, almost always turn out to be mistakes. As stock markets continue to rally, greed is emerging as the dominant emotion, and it's just as pernicious as fear. I hear it from the many people who have been asking me if it is too late to buy stocks now, who clearly want to hear that it isn't. At least they're asking, which suggests some degree of caution and willingness to think through the decision. Others are buying now, thinking about it later.

This is why I believe disciplined systems can be so helpful at separating emotion from reason. Asset-allocation models serve this function, in addition to providing welcome diversity. If you follow an asset-allocation plan, the recent stock market rally has driven up the value of your equity portion, and the slump in Treasurys has dragged that portion down. All else being equal, if you were at your equity allocation in March, you are now over it. To bring it into balance, you would have to sell -- not buy -- stocks now

I think the above statement about discipline and asset allocation is crucially important. At times I think the greates value of having someone with a personal relationship manage your investments with low cost index instruments instead of spending investment fees on an active manager of funds with no relationship with an individual comes with the discipline it provides.If course I am totally biased since that is what I do. Although ultimately of course it is the clients money the advisor can work very hard to limit the emotions involved in investing and making rash changes in reaction to market movements. Oftentimes I tell clients they are paying me not to let them make radical changes in their investments in reaction to short term movements. But generally after the third discussion I reluctantly make the change they want, as I noted ultimately it is their money.

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