When buying or selling investments, individuals act in a completely different way than when they shop for cars, groceries, and other consumer goods. These very different approaches to buy or sell decisions can explain why investors get such different, often disastrous outcomes when making financial investments.
Picture yourself buying a vehicle. What are the steps you take and what is the final outcome? First off, what type of car do you desire? Sports car, convertible, SUV, truck, or hybrid? Okay, so you have decided on a fuel efficient hybrid. Next you will research what is the best hybrid for your budget and preferences. You may search Google for reviews of various vehicles, talk to your local mechanic, or go for coffee with your friend the "car guy." Next is to decide on the options you must have. Power windows, heated seats - maybe a heated steering wheel for those of us in cooler climates.
Making the final decision will take a fair bit of time no matter how you cut it. Now you have the hardest part–to actually find a vehicle to buy in the real world. There will no doubt be haggling over the price. A rational consumer would not pay black-book value for a vehicle that has a big scratch on the driver's side door. In the end you may not even buy one because there is nothing for sale worthy of your hard earned money.
Consider your decision to sell a vehicle as well. Would you drive a brand new vehicle off the lot, panic because it just depreciated $5,000 in 5 minutes, turn around and sell it back to the dealer before it dropped any further? As a consumer, a rational sell decision is based on logical thought, not panic over the rapid change in price.
What about shopping for groceries? Aisle after aisle of ingredients, snacks, utensils, pharmaceuticals, a plethora of cheeses, 10 choices of rice - the list goes on. Most often consumers will go to the store with a list of items they want to purchase. Fruit, vegetables, grains, protein, and the odd guilty pleasure. When one of your items is on sale, you stock up.
Now, let's move over to "shopping" for investments. Too many investors view this as an entirely different thought process. But it's not.
Let's say you buy the average equity mutual fund. What do you get? On average, dozens if not hundreds of different stocks. Perhaps the portfolio manager has gone up and down every "aisle" in the stock market and bought one of everything. Where was their shopping list!? Further to that, how much can a portfolio manager know about each individual stock (business) they have? Very little, I would surmise. In the extreme case are equity ETFs, where there is a computer making the "decisions," and they do own everything in perfect proportion to the index they want to imitate.
One big difference between buying groceries and stocks is that with groceries, you rarely bring anything back to the store. Maybe the occasional jug of sour milk but that's about it. Not in the stock market. These "consumers" of stocks buy and sell with wild abandon often resulting in over 100 per cent of the shares in a mutual fund being bought and sold every year.
What happens in the stock market when prices plummet? General reaction is panic and investors heading for the exits together. Mutual funds are usually fully invested; holding little or no cash. How could they take advantage of sales in the stock market with no cash? Worse yet, when stocks are declining, investors panic and head back to their broker to sell their mutual funds at a lower price. This forces mutual fund managers to sell stocks when they are on sale. That's the time to be buying! Imagine applying this behaviour to buying groceries. Let's say your Corn Flakes have been marked down to half the usual retail price. The "stock market way" is to panic, bring back the box you bought last week and beg the store manager to take it off your hands at the sale price. Irrespective of the fact those Corn Flakes haven't changed, only the price has. No rational consumer does this.
My advice? When you invest, behave like a rational consumer. Behave like you do when you buy a car or groceries. That's our approach: research and decide on the few businesses that are worthy of purchasing. A shopping list if you will. Then only buy stocks when they are on sale. When these conditions don't prevail, sit on the sidelines until they do. Fortunately, we don't need stocks in our portfolio as we need food in our stomachs. To wait with cash and have patience is not easy, but it's rational. In the investing world today, there are few bargains in the equity aisle. We just have to wait until that gem of a vehicle shows up on Kijiji. Until then, we'll keep taking public transit with our bags of groceries we bought on sale.
Larry Sarbit is the CEO and chief investment officer at Winnipeg-based Sarbit Advisory Services. Mr. Sarbit is a sub-adviser on three funds for IA Clarington.