Ever had a gut feeling? You just knew you should buy XYZ stock but didn’t—whatever reason—then it skyrocketed 300 percent. Or you knew to sell ABC stock—but ignored your instinct—then it plummeted 80 percent. You have these feelings all the time, and they’re usually right—as you recall. But that’s also almost certainly your mind being your worst enemy and playing tricks on you.
There’s a major school of behavioral psychology now, called behavioral finance, dedicated to understanding how our brains evolved—to deal with basic problems of human survival—and why that leads to serious investing errors. Whole books have been and will be written on the topic, and it was the basis for my third question in my 2006 book, The Only Three Questions That Count.

Selective Memory and Other Messy Biases

Our brains produce some very basic bunk, making it difficult to deal with counterintuitive problems like publicly traded markets. And one major bit of bunk is the notion you should trust your gut. First, I’d ask if you really knew XYZ would rise so much. Or did you have a passing thought and built up your conviction only much later, after the fact? (Usually, it’s the latter.) Or do you suffer from hindsight bias? You were convinced in your gut that fully 20 different stocks were surefire winners, but in the end, they were all losers except XYZ. But you conveniently forget the ones you were wrong about, and remember the one that lets you crow about being a genius. That happens often—much more often than not—but your brain never catalogs it. (Many investing newsletters make this a regular practice, saying, “If you’d bought these six stocks we recommended, you’d be up a bajillion percent!” They conveniently don’t mention the other 874 stocks they touted that did badly.)
Investors tend to put a lot of stock (pun intended) in gut feelings—that gripping feeling to react NOW. It helped keep our ancestors alive. It’s called “fight or flight.” When a wild beast charged, they reacted immediately with flight. Or, if it was small enough, they pulled out a spear and took it home for dinner. It’s the instinct to “just do something”—and it worked for our long-distant ancestors.
Clients tell me all the time—and I mean regularly—when I’ve been wrong that they knew “the whole time” I was wrong. But they rarely did know the whole time. Instead they’re likely falling prey to hindsight and convenient memory. What really happened, almost always, was they hoped I was right and feared I was wrong, a perfectly natural instinct. That fear I was wrong in their minds morphed into them knowing I was wrong. The mind is a cruel trickster when it comes to markets.
In focus groups my firm runs on investors who are serious “hobbyist” investors and CEO types, we can document a tremendous propensity for investors to believe they knew 2007 to 2009 would go down the way it did—as a disaster bear market—and that “anyone could have seen it if they just used common sense and good instincts.” Of course, if they really knew, they would have sold out instead of getting hammered. Their memories play tricks on them.

Losses Feel Worse Than Gains Feel Good

It’s been measured and proven that US investors feel the pain of loss fully two and a half times as intensely as they enjoy the pleasure of gain.1 So a 10 percent loss feels about as bad as a 25 percent gain feels good—on average. On paper, that looks ridiculous. Your gut disagrees. And because for our ancestors, avoiding the risk of immediate pain increased longevity, investors’ guts tend to tell them to get out of the way if they fear a near-term loss—or a charging wildebeest. There’s even a term for it—myopic loss aversion. Another way to say that is “aggressive short-sightedness.”
In cooler moments, most investors with long-term growth goals agree they should think long term and ignore near-term wiggles. And they plan to. They have ice in their veins! But in the midst of volatility, more primal instincts take over—they want to take action to remove the threat of near-term pain, even if it costs them future returns. Why? Because that near-term pain feels so much darn worse than they can imagine those future gains will feel pleasant. Again, investors articulate notions like, “Don’t just sit there; do something.” It’s fight or flight. But sometimes doing nothing is doing something—and the best thing you can do.
Here’s an example: 1998 was a terrific year for US and world stocks. If you took a pill that knocked you out from January 1 until December 31—an entire year—it would have seemed glorious! But if you were conscious, it was trying. It started fine—world stocks shot nearly straight up 22 percent by mid-July.2 But folks feared a financial crisis in Asia that started in 1997 would bleed to the rest of the world—particularly since it led Russia to default on its debt and devalue the ruble (the famous “Russian Ruble crisis”). Debt woes trickled west, pushing huge and super-leveraged US hedge fund Long-Term Capital Management to the brink of default. Folks feared if LTCM failed, it could take down the US financial system—and world stocks went through a stomach-churning correction—down 20 percent in just 11 weeks!3 Yikes!
But corrections move fast because they’re grounded in sentiment, not fundamentals—and sentiment changes fast. Folks quickly got over their fears, and world stocks exploded back up 27 percent to finish the year up a big 24.3 percent overall (28.6 percent for US stocks).4 Investors who ignored their gut and stayed invested were rewarded—hugely. Investors who panicked and sold to stop the pain likely sold at a relative low, and most likely didn’t buy back fast—not in time for the fast rebound. Plus, they had to pay transaction fees and maybe taxes. Ouch!
Figure 7.1 shows 1998 global market returns. The solid arrow shows from start to finish, stocks did nicely! But it was no straight shot—stocks rarely climb in steady, smooth steps. The dashed lines show the huge, scary drop and the similarly fast rebound. And as big as the drop was, it felt, for most investors, more than twice as bad. If stocks fell 20 percent, it felt like a 50 percent free fall—or worse—for most folks. That’s serious terror. The big surge after was nice, but it felt like what it was—a big, 24 percent move. Nice—but not as nice as the plummet felt bad.
And you know that’s wrong. The year was up big. That’s what matters, not trying to dance around a lightning-fast down-up. But when it happens, our ancestral brains want to take over and do something. Folks like to think it’s possible to time corrections. If it is, no professional has done it consistently over a long time period—ever. So all you’ll likely do in trusting your gut and selling out at relative lows is pay more transaction fees and rob yourself of future gains. Sometimes, doing nothing is the most active strategy you can have. Folks think doing nothing is always easy—but it’s not! (See Bunk 17.) And that’s why it can pay off.
Figure 7.1 A Fine Year for Stocks—1998 Was Up 24.3%
Source: Thomson Reuters, MSCI Inc.,5 MSCI World Index total return with net dividends from 12/31/97 to12/31/98.
Next time you’re tempted to go with your gut, remember: Your Stone Age brain may be good with physical risk, but it is also the same one that governs your investment gut—and it’s a truly lousy investment manager.
..................Content has been hidden....................

You can't read the all page of ebook, please click here login for view all page.