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(Yakobchuk)
(Yakobchuk)

Taking Stock

How mind games can destroy a portfolio Add to ...

William Bernstein's latest book, The Investor's Manifesto , has the usual complement of tables, graphs and return calculations you'd expect in an investing manual. It also has something you don't normally see: a diagram of the human brain.

A retired neurologist, the 61-year-old author and money manager is as comfortable discussing the efficient market hypothesis as he is explaining the functions of the cerebral cortex and hippocampus. That gives him a unique - and sobering - perspective on the massive run-up in stock prices in the past year.

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As Mr. Bernstein explains it, the key to understanding why investors are merrily embracing risk again lies in two tiny bundles of neurons called the nuclei accumbens . Situated just behind each eye, they serve as the brain's "anticipation centre." If you've ever wondered where greed lives, it's here.

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"This lights up whenever we anticipate something good happening. And that something good could be food, it could be social contact, it could be sex, or it could be making a lot of money in the market," he said from his home in Portland, Ore.

Here's the problem: After a 76-per-cent advance in the S&P 500 since the market bottomed in March, 2009, investors' nuclei accumbens are lighting up like Christmas trees. And in this heightened state of anticipation investors are much more willing to take on risk by loading up on stocks.

And that's a big mistake, he said.

"The worst thing people could be doing is getting back into the market after prices have doubled," he said. "The primary mistake most small investors make is they confuse the economic outlook with returns going forward. In fact, the best forward-looking returns are obtained when the economy looks the worst, and the worst returns are obtained when the economy looks the best."

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It is a paradox that our feeble brains, built as they are for finding food and avoiding tigers and bears, can't seem to grasp. Which is why humans are forever buying at market tops, when all of the good news is already priced in to stocks, and selling at market bottoms, when stocks are bargain-priced.

Those who learn to do the opposite - that is, override their own brains - usually come out ahead, but most people can't resist what millions of years of evolution are telling them.

"We were hardwired for split-second, survival-directed decision making on the plains of Africa when you would see some yellow and black stripes in the corner of your vision and you ran like hell, whereas in modern society we're not planning over the next five minutes or next five seconds, we're planning over the next 50 years and our brains aren't wired for that."

So what remedy does the good doctor recommend? A surprisingly simple one.

Investors should start by allocating a percentage of their portfolio - roughly in line with their age - to fixed-income securities. For example, a 30-year-old investor should put 30 per cent of his or her money in bonds, while a 70-year-old should allocate 70 per cent. The age rule is merely a starting point, and can be adjusted depending on the investor's risk tolerance.

Mr. Bernstein recommends a well-diversified mixture of government and investment-grade corporate bonds. The duration, a measure of a bond's interest-rate sensitivity, should be kept to five years or less, which will provide some protection if rates and inflation rise.

Focusing on high-quality bonds is critical, he said. This is your sleep-at-night money, and you'll be glad you have it if the market is sideswiped by a terrorist attack, war or some other calamity that nobody is expecting. Even if inflation sets in, having short-term bonds will allow you to roll them over at interest rates that are rising.

For the equity portion of the portfolio, investors should spread their money across domestic and foreign stocks using broadly-diversified index funds. Keeping costs low and indexing are critical to successful investing, said Mr. Bernstein, who is skeptical that any active money manager can beat the index consistently.

Once your asset allocations are set, you can forget about your portfolio - for a while. Every few years you should rebalance your investments; that is, bring the allocations back into line with your desired targets, by selling some bonds and buying stocks or vice-versa. This will force you to acquire more equities when prices are low, and lighten up when prices are high.

Your brain may tell you it's the wrong thing to do. But when it comes to investing, your brain isn't as smart as you think. Sometimes it's downright stupid.

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