For most people, the information in today’s post is probably more important than any other single fact they can learn about investing. Understanding and following this advice could make a million-dollar difference for a middle-class family thinking about college and retirement.
The problem is that the advice is extremely difficult to follow. Since very few individuals will follow this advice, it is yet another source of market inefficiency. It explains why Warren Buffett and other managers can maintain a positive expectancy in gains over the market.
Ready? Here goes —
Don’t sell the bottom!
Don’t do it with stocks. Don’t do it with mutual funds.
Let me explain the psychology first, and then show you some persuasive evidence of the effects.
They psychology comes from our desire to control, and the feeling that we can control our investments. There is a strong marketing interest in persuading investors that they can and should make their own decisions. It is profitable for brokerages, and they run many ads to that effect.
They show the "Power Guy" with his fancy trading tools telling a broker (as if he would really be talking to a broker in these days of online trading). The Power Guy says "OK, I’ll buy a thousand shares, but if it goes down, I’m going to dump it!" Firm, decisive, and wrong! The market creates all sorts of movements in stocks. If your fundamental reasons are intact, you should be prepared to buy more. But it certainly sounds good. The TV commercial plays upon our desire to show that we are in control, and that this sort of decisiveness makes sense.
Another commercial theme for Diamonds (the ETF that is a Dow 30 equivalent) highlighted a woman who did not have the time to study individual stocks, but who had a "feel for the market." Just what people need — not! Encouragement to try market timing based upon casual knowledge. I wonder how much people have lost following that commercial.
And then there is the guy who spots a good investment because he is buying jeans for his daughter. This is a perversion of some great advice from Peter Lynch. It is fine to try to spot trends early. This provides a nice starting point, not the reason for an immediate investment.
The sad result is that individual investors make 1/3 to 1/2 of the market returns in every study I have seen on the subject. Here is one such study, and there are many more.
Warren Buffett says the following:
"You can’t get rich with a weather vane."
"The market is there only as a reference point to see if anybody is offering to do anything foolish. When we invest in stocks, we invest in businesses."
If you are not studying the individual companies, the financials, the trends, you are not analyzing the business.
In many stocks right now the market is offering an opportunity. There is an extremely high level of concern, not about current conditions, but about an expectation that the Fed or oil prices or budget deficits, or something, will ruin the economy. Before concluding that the market (which has predicted seven out of the last two recessions) has some great message, the investor should get some evidence.
The studies also show that the average investor applies the same criteria to investment managers, selling funds that did poorly recently to buy those that did well. The investor is not making a careful decision because this strategy has been proven to work. In fact, it has been proven to be a loser. Investors behave this way because they want a simple rule, called a heuristic in behavioral finance, and this is the only information they have. It gives the illusion of control, and costs them many thousands of dollars.