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People behave oddly in crazy markets. It never fails. Fear drives the ship and it’s not pretty. Since the market is relatively calm right now, I thought it would be a great time to discuss this.

For starters, check out this video that explains how investors consistently act irrationally, especially in crazy markets.

But It’s So Simple

If you had $100,000 in your retirement plan on June 30th, 1975 and all of it was in the Vanguard Morgan Fund, do you know what it would be worth March 31st of 2016? I’ll help you out… $7,327,955.90. Sounds like a winner, right? And that doesn’t even account for any contributions! Here’s the Morningstar chart showing the fund’s growth.

The Vanguard Morgan Fund’s performance is solid, but it’s actually nothing special. If you look closely at the chart, you’ll see the Vanguard Morgan Fund nearly overlaps the S&P 500 benchmark. In other words, this fund is tracking very close to the return of many people’s definition of “the market”. It’s just average. Nothing sexy.

The Average Investor

So that’s the average fund. Pretty basic. And then there’s the average investor who cannot even keep up with the most basic fund tracking the market. In fact, the average investor regularly gets crushed by the market over time. For starters, you must understand investor’s behavior to see why this occurs.

People get greedy and buy, get scared and sell, and start over. It’s a vicious cycle. It’d be like going to buy all new clothes because your favorite store announced a 20% price hike. Nobody does that – except with investments.

Here are some real numbers for you…
Mutual Fund Cash Flow

This illustration which can be found at Bogleheads shows the historical net cash flow numbers of mutual funds. It’s quite obvious. People buy when the market is up and sell when it’s down. And that’s part one of the problem.

But, you’re probably an intelligent investor, right? Or if you’re not, you likely have someone helping you that is. Intelligent investors realize that people have a tendency to buy high and sell low. So does that mean you’re okay as long as you’re informed or you pay someone that’s informed? Not really. The reason is overconfidence, which is part two of the problem.

Overconfidence

People overwhelmingly think they’re above average. Especially informed people. Informed investors or advisors read what I just said and say something like… “Yeah, that’s true. Average investors do that. But I’m not average. I’ve spent hours researching and know this stuff.” This is called overconfidence. And it actually increases the chances of irrational investor behavior in crazy markets. And, surprisingly, it gets worse the “smarter” people are.

There are exceptions. Sometimes people that know very little about subjects, like investing, aren’t affected by overconfidence directly. But their advisors certainly are.

In 2006, a researcher named James Montier surveyed 300 professional fund managers. He found that 74% believed they had delivered above-average job performance. Many wrote comments along the lines of “I know everyone says they are, but I really am”. Almost 100% of the group believed that their job performance was average or better. The reality is that 50% should be below average and 50% should be above average. But overconfidence causes people to believe differently.

Overconfidence is not limited to investing:

  • In a US survey, 93% of the sampled drivers rated their driving skills in the top 50% (Svenson, 1981)
  • Nearly 80% of people believe they are among the top 50% most emotionally intelligent people (Salovey, 2006)
  • In a survey of faculty at the University of Nebraska, 68% rated themselves in the top 25% for teaching ability (Cross, 1997)
  • In ability to get on well with others, 85% put themselves above the median, and 25% rated themselves in the top 1% (College Board, 1976)


People tend to think they’re better than they really are. Who reading this is below average at their job? Nobody, right?

I’m sure many of you are thinking now… I’m an exception to this rule. In fact, I find myself thinking that as I type. I have years of experience helping people invest. That’s how it works. The key is to acknowledge that’s how people work and to train yourself to avoid acting based upon the natural tendency to think you’re always above the “average”. Especially when investing in crazy markets.

The Roller Coaster Experience

Let’s consider the Vanguard Morgan Fund example. It’s a tough road to go from $100K to over $7M filled with short periods of roller coaster markets and overconfidence. Let’s assume on June 30th, 1975 you’re 20 years old and receive an inheritance of $100,000 – all of which is invested in this fund. Your plan is to keep this investment for the long haul – you don’t really need the money now. The challenge is managing all the noise going on around you. There’s home run business deals with buddies. There’s individual stock picks your broker friend says are easy home runs. There’s beat the market books. There’s also lifestyle temptations that creep up. You’re looking to buy your first home in the early 1980’s and realize mortgage interest rates are over 15%.

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With an interest rate over 15%, who could blame you for eyeing the boring old mutual fund as an alternative. When you look at how the mutual is doing, you realize it went down in value in 1981 and you’re paying 15% for a mortgage! You’d have to be ignorant not to sell your Vanguard Fund and pay off the mortgage. Fortunately you are ignorant and don’t sell.

And then come the 1990’s and technology is taking off. People are becoming overnight millionaires from owning tech stocks. People are talking about stocks like Cisco (CSCO) being the next big thing. You look at CSCO in 12/31/1997 and the price is at 9.29 per share. You take a pass on it. But you’re curious and check it again 3/31/2000 and it’s at 77.31. That’s more than 8X growth in just over two years, far more than you’re getting in your Morgan Fund. Maybe this is your second opportunity. Everybody you know is doing it. Against all logic, you don’t do it! And it’s for the better. If you had moved your Morgan Fund on 3/31/2000, which was up to $4,140,808.80 all into CSCO it would be worth $1,524,884.58 as of March 31st 2016! But, fortunately, through all of this you stay the course.

Fast forward to June 30th, 2000. You’re now 45 and the balance has grown to $3,952,529.60. You’re feeling pretty smart after more than tripling your money in 5 years. After all, most people you know gave into all the temptations over the past 25 years and dumped the boring old Vanguard Morgan Fund for something better. But you we’re different. You knew this would turn out to be the best investment. However, you’re starting to feel more concerned about the possibility of losing it all. As the tech bubble bursts, you begin hearing of people that lost everything. If you’re going to get out, now is the time. But why get rid of something that’s done so well for so long. You stay the course.

The early 2000’s aren’t pretty. By September 30th, 2002, your balance has dropped to $2,075,806.40. You’re not feeling so smart anymore. People are saying this recession is different and that it may never recover. Everything inside you wants to sell but you can’t muster up the courage to do it when it’s so low. That would be totally stupid, so against your will you hang onto it in hopes of recovery.

It does.

By March 31st, 2007, it’s now up to $4,020,888.30. You’re finally above where you were in June of 2000 which is a big relief. Although you’re not feeling near as confident as you did back then, it’s getting better. You just recovered back to square one and things are looking pretty good. You’re considering buying some real estate properties with some buddies in your favorite vacation spots. It’s returned very well and everyone knows real estate doesn’t go down. And you’ve been thinking about diversifying your portfolio – it’s probably not a good idea to own one fund your entire life. Your about to pull the trigger when a great deal gets teed up by two of your buddies – it’s a great investment and you can use it for vacations. But once again, you do nothing.

And that’s when the bottom drops out. By the time you realize we’re in a major recession, your account is down big. By March 31st, 2009, your account is back down to $2,468,191.70. You’re 54 by this time. If the market hadn’t tanked, you’d probably be retiring soon. But after losing $2 Million, you’re feeling sick to your stomach. By this time, everyone knows it’s really bad. And most people think it will get worse. The economy is now the top news story… here are some headlines from March 2009. From the Wall Street Journal, “Dow 5000? There’s a Case for It” and The New York Times, “Steep Market Drops Highlight Despair Over Rescue Efforts”.

At this point, you’re done with all the ups and downs. All you really care about is retiring. You were counting on having at least $4 Mil in this account. But that’s not happening. You’re starting to think maybe you can make it work by going to cash and working for a few more years. A financial advisor friend is suggesting you ought to look at this annuity that offers all sorts of downside protection and upside potential. Or maybe you should stay the course. It’s another crossroads where you must make a decision.

Let’s look at all three options…

1) You go to cash with all $2.5 million because you feel like there’s no other solid alternative. And because interest rates are so low, you don’t earn much. There really isn’t an obvious time to get back into the market. Really you’ve lost your taste for investing as a whole. Fast forward to March 31st, 2016 and you’re sitting around $2.8 million. But that’s better than nothing right?

2) You buy the “safe” annuity with all the bells and whistles and realize 5% returns each year. By March 31st 2016, you’re back up to around $3.47 Million. Not bad, except the annuity has all these surrender charges you didn’t quite understand. As a result, you’re locked into it and unable to retire. Although better than holding cash, it’s not great. You eventually convince yourself it was a pretty good move… even though it was a terrible decision.

3) You stay invested and almost as quickly as it goes down, it comes right back up (and then some). By March 31st 2016, you’re up to $7,326,955.90 and feeling pretty good.

This one decision results in a range of outcomes varying by over $4.5 Million. It’s a make or break decision. And if you look back at the past, each and every decision produces similar results. Add several together and it gets much more extreme. It takes a special person to do NOTHING for this long of a period of time. Especially in crazy markets. These days, people love to talk about how they buy and hold. But if you look at their portfolio nothing is older than a few years. Investors that own lots of really old and boring investments like the Vanguard Morgan Fund, are few and far between. If you find them, odds are they’re wealthy.

Bringing It All Together

It’s very simple to have a successful investing experience if you do the following:

1) Invest in non-sexy investments like low cost, index funds that seek to track the market
2) Before the next crazy market happens, understand the potential highs and lows with your investments. Think about how it will affect your emotions. If it’s too much for you, consider minor adjustments.
3) Learn to spot overconfidence in yourself and others. Don’t let it get the best of you.
4) Don’t chase the next shiny object. Stick to your guns.

Or if you’re working with an advisor, make sure they’re operating under these rules. It’ll pay huge dividends long term, especially when the market gets crazy again.

Do you have any good stories where you or people you know made really bad investing decisions? Please share so we can learn from the mistakes of others!

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