by Gene Dongieux, CIO, Mercer Advisors
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Investment psychology confirms that emotion and intuition lead individual investors astray. Intuition, while great for making some decisions, leads investors to buy and sell at the worst times. For example, stocks are down this year. Investors who rely on intuition have been selling and taking money out of the market, holding back investment cash, or both. In contrast, in his annual meeting last May, Warren Buffet said that he loves buying in bear markets. Who has the best track record here, do you think?
The next logical step is studying how investors move in packs. We have had two real-life case studies of this in the last year, one on a macroeconomic scale, and one in the top reaches of finance.
The large-scale example is the credit crunch. You've probably read a lot about the nuts and bolts of how it happened, but here's the psychological view: mortgage lenders, private equity firms, and investment brokers entered into a juggling game with individuals, who served as both real estate buyers and investors. As long as everyone kept participating, all the balls stayed in the air. When one player slowed down, there was a mad scramble to get out of the game and avoid losses. Though big-firm writedowns have made more headlines, those who suffered the most were individual investors, who didn't realize they were part of a game.
The upper echelon example is Bear Stearns, which collapsed this year. Following its bailout, everyone wanted to know how such a large and prominent firm could get into such deep trouble without anyone knowing. The answer is that it had not been in trouble. The trouble was an illusion, but this illusion was strong enough to kill the company.
When Bear Stearns' stock started falling, no one was more surprised than Bear Stearns. Upon calling around, they learned there was a rumor in the financial community that Bear's cash reserves were low. In fact, they were more than adequate, but fighting a rumor is like fighting smoke — even denying the rumor fans the flame.
Bear's creditors did much the same thing that firms did when the credit crunch hit: race for the exits. Once Bear's first creditor withdrew, others followed even though there was no reason to panic. Thus, Bear's creditors created their own problem. Because all of Bear's creditors demanded immediate payment in full, Bear went under.
There are three lessons here. One is that rational behavior can create a better outcome for everyone in the financial industry, from individual investors to the Chairman of the Federal Reserve Board (who negotiated the Bear Stearns bailout). The second lesson is that it isn't easy to behave rationally. Rationality means acknowledging and overcoming the impulse to react, and even people who should know better can't always do it. The final lesson is that even when irrational actions have gotten individual investors or whole companies into trouble (dot-com bomb, fund closures, junk bonds, and more), the market has endured and thrived.
Rational investing says that the market moves in cycles. We don't know when or how much, but based on history, we know to expect ups and downs. We also know from history that the first part of a market rebound is the strongest and has been not only hard to predict, but hard to recognize; like many features of market movement, a rebound is labeled after the fact. So the best way to be around for the rebound is to invest while the market is down. This is the "buy low" part of "buy low, sell high."
Now Warren Buffet's enthusiasm for bear markets makes more sense. If you are one of the many investors sitting on cash, you're missing the opportunity to buy low and make more in a future rebound. Investing right now may not feel like the right thing to do, but it is the rational thing to do. It is the wise way to play to win the long-term investment game.
Gene Dongieux is the author of "If You Have It Made, Don't Risk It: A Physician's and Dentist's Guide to Investing." As chief investment officer for Mercer Advisors, he manages more than $3 billion in client assets. Dongieux has been quoted in The Wall Street Journal and Investment Advisor magazine. Contact him at [email protected].