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(David Zalubowski)
(David Zalubowski)

Strategy

Why investors often act like cattle Add to ...

It's an example of poor asset allocation writ large: Thanks to panic induced from watching the stock market plunge, investors shifted about $200-billion out of U.S. equity funds between September of 2008 and March 9, 2009.

The S&P 500 Index ultimately fell by 58 per cent from its peak. But the money that fled did so before the stock market rallied to 90 per cent of its original level, notes Joel Clark, managing principal of the private client services team at Toronto-based investment management firm KJ Harrison & Partners Inc.

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Much of the money taken out of the stock market was invested in bonds. "From our perspective, that might be the single worst capital allocation mistake over the next decade," Mr. Clark said. "It speaks to this zigging when you should be zagging, and zagging when you should be zigging."

When it comes to investing long term, human nature often works against us.

It's something that Joel Cuperfain, an estate planning specialist with RBC Wealth Management, sees regularly. Sometimes it's intentional - for instance, investors will pare back their risks, and potential returns, for safety. That can be a wise move.

Mr. Cuperfain recently sat in on a meeting between an investment adviser and a 65-year-old client who had intentionally decided to sacrifice potential returns in order for security.

"The investment adviser said to the client, 'Last year was not a bad year, you did six per cent. That would have been a lot higher, but we pulled out of a lot of equities because you were concerned about what happened in 2009 and so we had to shift a big part of the portfolio to fixed income.' And the client said, 'I know that I could have done better in 2010, but I slept really well last year.'"

But, many times, investors' natural tendencies steer them down the less lucrative path, unbeknownst to themselves.

The biggest threat to reaching retirement goals is making capital allocation mistakes along the way, said Mr. Clark. "It really stems from the fact that, basically, as human beings we are inherently prone to making irrational decisions when it comes to investing."

The Herding Effect

One psychological flaw that investors fall prey to is what's known as the herding effect. That's the tendency for people to mimic the actions of a larger group, whether those actions are rational or irrational.

This was famously demonstrated in a 1958 experiment by social psychologist Solomon Asch. He set up a study in which participants looked at a vertical line in one exhibit and were told to choose the line in the next exhibit that was the same length. The correct answer to this visual test was painfully obvious. But in instances where a number of fake participants were recruited and told to give the same wrong answer out loud, the unknowing participant would follow the herd and choose the incorrect answer more than one-third of the time.

"Often times, people believe that the group is right. They think they must know something that I don't know," said Sarah Bull, a principal of the KJ Harrison private client services team. "Herd behaviour has really been a big element of financial history, both how markets have performed and how individual investors invest."

What that means, she added, is that investors tend to do the wrong thing at the wrong time. "What we're supposed to do is buy low and sell high, but what investors generally do is the exact opposite," she said. "There's a cost to being led astray."

This cost is easily illustrated by the tech boom of a decade ago. Investors threw money at tech stocks. "Other people were doing it, the headlines were saying it, and so people followed that," Ms. Bull said.

As Kevin Strain, senior vice-president of individual insurance and investments at Sun Life Financial, puts it, "I keep thinking about Nortel - how many people said at $20 it was a great buy, [then]how many people said at $2 it couldn't go any lower."

The Vividness Bias

There are further human tendencies that work against us. One is something known as "vividness bias," which describes how people are often influenced by what's loud and in their faces.

"The vividness bias occurs when you look at bonds, and you look at the returns and you go, 'Okay, 30 years, great run, it's going to keep going,'" said Philip Lieberman, another principal on the KJ Harrison team.

"It's how our industry is set up," added Mr. Clark. "The investment industry sells its track records, so it sells the 30-year bond market performance. It can't sell a 30-year bear market performance, but that's exactly how you should invest."

What tends to sell is what's already hot, and what's already hot is likely overvalued. Take, for example, Wal-Mart Stores Inc., which received an enormous amount of publicity about a decade ago. In 2000, the market paid 38 times earnings for that stock, compared with 13 times earnings today.

"Ten years ago, Wal-Mart was too expensive to be buying," said Mr. Lieberman.

Another problem is that investments tend to overshoot, noted Mr. Clark. "They go past the logical point, so in the tech days Nortel was overvalued from 1997 to March, 2000."

That's enough time for smart investors to second guess themselves and for others to follow the herd. Of course, just because a stock has been rising for a long time doesn't mean it can't be a good buy: The key, experts say, is to step back from the hype and the track record and analyze the fundamentals.

Follow on Twitter: @taraperkins

 

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