Guest Author: Meir Statman – Bio at end of article
By November 2010 the stock market has given us back half of what it had robbed from us through February 2009, but we are still afraid. We feel as if the stock market is lying in ambush, ready to pounce as soon as we venture in. We are afraid that the stock market would again try to take away from us all we have saved for our retirement years during our hard working years.
It would be easy to me to predict that the stock market would go up or down during the coming year, that bonds would do poorly and gold would do well. It would be easy for me to tell you that we are in a “new era,” where smart investors time the market, jumping from stocks to bonds and back again, and only fools buy and hold diversified portfolios of stocks, bonds, and many other investments. After all, what do I have to lose? You would forget my predictions before the year is out.
I will do none of that. Instead, I will share with you some lessons I have learned from my studies of behavioral finance, studies reflected in my new book, What Investors Really Want. I have learned that we should be aware of our cognitive errors and emotions. And I have learned that we should use the tools of science to overcome them.
Diversification did not fail in 2008, only a caricature of it failed. The caricature of diversification promises that it would prevent all losses, but this is not what diversification promises. Diversification promises that they will never have your entire portfolio in the worst performing investment. In return, you give up any chance that your entire portfolio would be in the best performing investment. Diversification delivered what it had promised. For instance, U.S. stocks lost 37% in 2008 while international stocks lost 44%. The gap between the two returns was 7 percentage points. The roles of U.S. stocks and international stocks were reversed in 2009 when U.S. stocks gained 29% and international stocks gained 36%. The gap was 7 percentage points that year as well.
Losing 44% is very painful. Losing 37% is still very painful. Both losses leave us feeling as if we are sitting in the proverbial frying pan of diversification. We are tempted to jump from the frying pan into the proverbial fire of market timing, but we are wise to rely on science and resist that temptation.
Hindsight error is one cognitive error which traps us. It is easy for us to fall into that trap and believe that we knew in 2007 that stocks were about to tumble. We probably thought so in 2007, but with many caveats. Perhaps the tumble would come, we might have thought, but not before 2010. Hindsight errors erase those caveats. Framing errors pose another trap. If we are selling stocks because stocks are sure to tumble, who are the idiots who are buying them? We tend to neglect the likelihood that we are the idiots. Some say that we can time the market by selling stocks when price-earnings-ratios are high and buying them when price-earnings-ratios are low, but I have found in several of my studies that market timing rules based on price-earnings-ratios are generally inferior to buy-and-hold rules.
I hope that the coming year would turn all our investments into winners. Still, I remind myself that my foresight is not nearly as clear as my hindsight and so I hold on to my diversified portfolio. You might wish to do the same.
Egos and Riches by Meir Statman
Book Review: “What Investors Really Want” by Meir Statman by John Lounsbury
Guest Author: Meir Statman is Glenn Klimek Professor of Finance at Santa Clara University and Visiting Professor of Finance at Tilburg University – Netherlands. His research on behavioral finance has been supported by the National Science Foundation, CFA Institute, and Investment Management Consultants Association (IMCA) and has been published in the Journal of Finance, Financial Analysts Journal, Journal of Portfolio Management, and many other publications. He is author of the just published book “What Investors Really Want” and writes at his blog What Investors Want. For further information see Vita.