Fear of Admitting Investing Mistakes Can Cause Bigger Investing Mistakes

Beyond Buy-and-Hold # 45

You?re walking down the street and a fellow offers you a proposition. He will flip a coin. You will say in advance whether you think it will turn up heads or tails. If you are wrong, you will pay him $10. If you are right, he will pay you $20.

The fellow is offering you odds strongly in your favor. There?s a 50 percent chance that you will lose money. But there?s also a 50 percent chance that you will gain twice that amount of money. Logic says that this is a good bet to take. Casinos get rich by setting things up so that they can be on the right side of bets like this. This fellow is offering you the opportunity to enjoy the edge ordinarily possesses only by casinos.

The behavioral finance literature teaches us that, if you are like most people, you will turn the fellow down.

Our aversion to losses is greater than the joy we feel in response to wins. Intellectually, the proposition being offered you is a winner. Emotionally, the edge you are being offered is probably not sufficient to persuade you to take a chance on suffering a loss.

One of the reasons why Buy-and-Hold investing strategies are so popular despite 30 years of academic research showing that they never work for the long-term investor is that Buy-and-Hold appeals to the irrational aversion to losses felt by all human investors (and that?s pretty much all of us!). Buy-and-Holders suffer far larger losses over an investing lifetime than Valuation-Informed Indexers. But they don?t feel as much emotional pain in response to those losses.

Valuation-Informed Indexers lower their stock allocations when stock prices rise so high that the odds of seeing a good long-term return from stocks drops very low. That?s the situation that has applied since January 1996. Valuation-Informed Indexers who lowered their stock allocations in 1996 felt a good bit of emotional pain in 1997, 1998 and 1999, when stock prices soared. They were doing the right thing; the value proposition being offered by stocks at the time was poor. Still, they felt as if they had lost money by doing the right thing. They felt bad about doing the right thing.

It?s the Buy-and-Holders who have been feeling bad in the years since. Or at least they should have been. The portfolios of those invested in stocks have barely been keeping up with inflation since 2000. But most Buy-and-Holders continue to argue that their strategy makes sense even after 11 years of poor performance. What gives?

Buy-and-Holders don?t blame their strategy when it performs poorly. They blame the economy. They argue that stock crashes just happen randomly, that there is no correlation between the insane prices that were brought on by the massive promotion of Buy-and-Hold and the economic crisis that followed. So Buy-and-Holders feel displeased about the results they have obtained but do not accept personal fault for having caused those poor returns. It?s an emotionally less painful way to cope with things.

It?s also less honest. And less enriching in the long run. If Buy-and-Holders could accept that they caused their own financial destruction, they could become far better investors in the future than they have ever been in the past.

By blaming the economy, Buy-and-Holders diminish the pressure they would otherwise feel to consider new strategies. By sticking with discredited strategies, they cause their financial pain to increase. In the long run, they feel more emotional pain than they would have if they were more honest with themselves about the mistake they made when they bought into a strategy with such a poor historical track record.

We all make mistakes. That?s how we get better at the things we do over time. The worst mistake you can make is to fail to admit your mistakes because of a desire to escape the emotional pain that comes with doing so. Unacknowledged mistakes compound. The Buy-and-Holders have set themselves up for a whole big bunch of pain in days to come.

Buy-and-Hold is a ?stick to it? investing strategy. That?s good. Too many investors change strategies too often, never giving any one strategy enough time to prove itself.

But you have to be especially careful when following a ?stick to it? strategy not to become arrogant and defensive. What if you got something wrong and the strategy to which you are sticking is doomed? In that event your portfolio is doomed too.

Those of us who follow ?stick to it? strategies (Valuation-Informed Indexing is a ?stick to it? strategy too) need to make special efforts to keep our minds open to hearing other points of view. We?re learning new things about stock investing all the time. We don?t want to become so enthused about the cutting-edge thinking of an earlier decade that we hold tight to it even after it has been discredited.

But maybe I?m wrong!

Rob Bennett argues that it is essential to follow a valuation-informed strategy when investing in index funds. Rob?s bio is here.

( Photo from Flickr by Helico )

4 Responses to Fear of Admitting Investing Mistakes Can Cause Bigger Investing Mistakes

  1. How many different ways can you say it Rob?

    It’s always good to hear your voice, Ken, Thanks for stopping by.

    I’ve come to believe that the word “valuations” covers 70 percent of what we need to know about stock investing. The social stigma that stops us from discussing valuations frankly and plainly and clearly is killing us. Investing is important and we’ve taken 70 percent of what we need to know about this important topic off the table of permitted discussion.

    The reason why valuations are so important is that valuations = emotions. It is only investor emotion that can ever cause overvaluation or undervaluation. When investors are rational, stocks are priced properly. So knowing the extent of overvaluation or undervaluation tells us the extent to which we are off the mark in our understanding of how stock investing works. If you look at the historical record, you see that there has never been a time when we went as far off the mark as we did during the Buy-and-Hold years.

    It is by talking about our emotions that we come to terms with them. The more we talk about valuations, the better investors we all become. All of our investing troubles come from our unwillingness to engage in frank discussions of valuations/emotions.

    We are blessed to live in a time when coming to an intellectual understanding of stock investing is easier than it has ever been before. There’s more information and research available to us than was available at any earlier time. But the information and research does us no good until we work up the courage to talk about valuations/emotions. We cannot get this right without taking that big step.

    Shiller’s finding that valuations affect long-term returns was revolutionary. It is equivalent (in economic terms) to the finding that the earth is round or that the earth rotates around the sun rather than the other way around. We are in the very early days of exploring the far-reaching implications of this discovery. It will be decades before we come fully to terms with it. The entire vocabulary of investing discussions will change. The only reason why many do not see it today is that the change is so big that people’s minds cannot easily take it all in.

    That’s my take, in any event. There are many good and smart people who believe strongly that I don’t know what I’m talking about. So people listening in need to be sure to check out both sides.

    Rob

  2. People also make better decisions when they re-evaluate their core beliefs relatively frequently.

    I’ve been using buy-and-hold investing so far, but I have only been buying for 2 years or so. I’d be open to switching to valuation, after hearing some more about it. But it’s difficult to know when the right time to switch is.

  3. Thanks much for stopping by, Kellen.

    Lots of people (including many very smart people) get hung up on this question of “When to switch?”. I can only tell you what I believe, based on the many years of in-depth research I’ve directed to this matter.

    There is no way to know when the right time is.

    That’s what I believe. I could tell you “Switch now” and stocks could do great for two years. I could say “Wait until next year” and stocks could collapse next week. I have zero confidence in my ability (or in the ability of anyone else) to tell you how stocks are going to perform over the next year or two. My recommendation is that you stop trying to do that because you will never be able to get it right consistently.

    What I can tell you is this — There has never yet in U.S. history been a time when stocks provided a good long-term return starting from the sorts of prices that apply today. That’s an objective fact. The historical stock-return data is available on the web. You can look this up for yourself and find out whether I am telling it to you straight.

    Given that stocks have never provided a good long-term return starting from these prices (and given that common sense tells us that stocks never can provide a good long-term return starting from today’s prices), my thought is — Why stay heavily invested in them? Why not wait until prices are better to put your money heavily into stocks?

    You have to focus on the long-term. Only the long-term is predictable. If you lower your stock allocation today and then increase it again six months from now because there is not a crash in that time, you are going to get killed. If you lower your allocation, you must know WHY you are doing this. You should be doing it because the long-term return is virtually certain to be poor starting from today’s prices.

    People need to stop trying to guess which way stock prices are going over the next year or two and focus instead on long-term value propositions. The long-term value proposition for stocks is today poor. It doesn’t matter what stock prices do over the next six months. The only thing that matters is that the value proposition is poor. You should aim to be heavily invested in stocks only when the long-term value proposition is either good or at least okay.

    As always, I am only offering one fellow’s take re all this stuff. Lots of good and smart people think I am 100 percent off my rocker. Perhaps they are on to something. If they were, I would probably be the last to see it, right?

    Rob

Leave a reply