There?s No Such Thing As An Unemotional Investor

Beyond Buy-and-Hold #19

By Rob Bennett

Is it better to follow where reason leads when making investment decisions? Or to give in to the pull of emotion?

Everyone agrees that investors should aim for rationality. The difference is in how they go about doing this.

Buy-and-Holders aim to be unemotional investors. They ground their strategies in analyses of the historical stock-return data and in the findings of academic research. Stick to the objective and you can avoid the emotional traps, according to this school of thought.

I view this as a failed approach. It was worth a try. But it didn?t work out. It?s time to move on.

An exit strategy?a day too late

Taylor Larimore, the co-author of the book ?The Bogleheads Guide to Investing,? posts regularly at the forum. He was asked a month or two before the crash whether he would consider lowering his stock allocation if prices fell hard. He ruled out the possibility, explaining that that would be the sort of emotional decision that causes many investors to obtain poor long-term results. Shortly after the crash, he revealed that all along he had a ?Plan B? that he planned to follow only in the event of a stock crash and that called for him to lower his stock allocation in the aftermath of a big price drop. His choice wasn?t an emotional one, he said, because it had been part of his secret plan all along.

Bill Bengen, a financial planner in California and the author of one of the Old School safe withdrawal rate studies, justified his decision to tell his clients to get out of stocks in the wake of the crash on similar grounds. Bengen?s retirement research assumes that those following it will never try to time the market, that they will maintain the same stock allocation for the long term. But the crash changed everything, he argued. This was a special event and it made no sense to follow the old rules after a special event had taken place.

It?s not my intent here to pick on Larimore and Bengen. Millions of Buy-and-Holder did what they did. They talked the Buy-and-Hold talk but the first time the theory was tested in a serious way they failed to walk the Buy-and-Hold walk. The human is The Rationalizing Animal. We do it so well that we fool ourselves into not thinking that we are doing it. We do this all the time.

When conventional investment wisdom fails us

You?ve heard many times that the average long-term return on stocks is 6.5 percent real. The Buy-and-Holders often point out that, so long as you never panic and sell your stocks, this is the return you can expect to obtain. It?s this argument that has convinced so many middle-class Americans to become Buy-and-Holders themselves.

There?s a part of the story that they don?t tell you. Stock prices fell 89 percent from their 1929 highs after that price bubble popped. What percentage of middle-class investors do you think it was that held their stocks over years in which 89 percent of the accumulated wealth of a lifetime wasted away? My guess is that the answer to this one is — a number closely approaching zero.

It doesn?t work. It sounds good in theory. But the reality of losing nine-tenths of our life savings is too painful for any of us to take. At least that?s the historical reality. I have never heard a name put forward of a stock investor who stuck to his stock allocation through the entire length of a secular bear market. If no one has ever managed this feat before, why would any of us believe that we are going to be the first?

The elephant in the room that no one wants to talk about

Emotion is the enemy. That the Buy-and-Holders got right. What they got wrong was the solution to the problem. The Buy-and-Holders ignore emotion. They pretend it doesn?t exist. They act as if we can overcome our emotions through an act of will.

I believe that we need to take it totally the other way. Valuation-Informed Indexers don?t ignore their emotions. The model is premised on a belief that dealing successfully with his emotions is the most important task that the long-term investor must perform. We know that price drops of 89 percent don?t turn up randomly. They always take place starting from times of insanely high prices. So the risk of us seeing an emotionally upsetting price crash is obviously much greater when stocks are high-priced. Naturally, Valuation-Informed Indexers lower their stock allocations at times of high prices.

Ignore your emotions, and they are going to sneak up on you and destroy your hopes for a good retirement. Acknowledge the power of your emotions to undermine your investment strategy, take them into account in the development of your strategy, and the problem of investor emotion can be easily overcome. I didn?t panic in the wake of the crash like Larimore and Bengen. I was going with a zero stock allocation at the time. There was nothing for me to panic about!

It?s an impossibility for Buy-and-Holders to escape stock crashes. We see one every 30 years or so and it takes roughly 40 years for a middle-class worker to build up the capital needed to finance a nice middle-class retirement. So we all should know on the day we buy our first share of stock that an event will be taking place sometime before we turn 65 that will threaten to destroy years of saving and investing effort. The question is — What are we going to do about it?

Rob Bennett developed a unique asset allocation calculator. His bio is here.

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5 Responses to There?s No Such Thing As An Unemotional Investor

  1. Here is a link to the original thread containing his comments so the readers can judge for themselves.

    Fair enough, Evelyn.


  2. A portfolio appropriately allocated for one’s age will less affected by such crashes. We are now too heavily allocated in stock, but are still years from retiring. As we get closer, I’ll change the mix.
    The four pillars of investing is a good read on this topic.

  3. The four pillars of investing is a good read on this topic.

    Thanks for stopping by, Joe.

    Chapter Two of Four Pillars is my favorite chapter of any investing book I have read. However, I have a hard time reconciling the message of Chapter Two with the messages of all the other chapters. Chapter Two says that valuations matter. The other chapters advocate Buy-and-Hold. I see a conflict there. Many others do not.


  4. Joe:

    If you’re having trouble making sense of my difficulty integrating what Bernstein says in Chapter Two with what Bernstein says in the other chapters of his book, you might want to take a look at a comment that was posted just a few minutes ago to the blog of Michael Kitces (a financial planner) by Joe Pitzi, also a financial planner. Here’s a link to the thread:

    Pitzi says: “I find it amusing that some planners consider anything other than passive investing to be market timing. What you are describing here as “tactical” is essentially what you find in the teachings of Benjamin Graham. In his book, The Intelligent Investor, he outlines that investors ought to stay between 25% and 75% stocks at all times, and that valuations ought to be the driving force behind that decision. That provides a whopping 50% swing in your allocation to stocks when markets are extremely overvalued versus extremely undervalued. I would hardly call Graham a market timer…which leads me to ask, isn’t this simply value investing?

    “I submit that this concept is precisely what “value investors” like Grantham, Eveillard, Klarman, de Lardelmelle, Romick, Hussman and Leuthold preach year in and year out…. There is no reason you cannot integrate a “value investing” strategy using index funds… You will never convince me that a 60/40 portfolio had the same risk in 2009 as it did in 2007. If you define risk as volatility (as the academic world tends to do), then the portfolio in 2009 actually had more risk. For a long-term investor, I submit that this definition of risk does not make sense. If you define risk as permanent impairment of capital (as value investors do), the opposite is true. A portfolio with higher prices, by definition, must have more risk than the exact same portfolio with lower prices.”

    I’m with Pitzi. I believe that stocks are dramatically more risky at times of high prices (like today) than they are at times of moderate or low prices. Thus, I do not believe that we should be staying at the same stock allocation at all times. We should be aiming to keep our risk profiles constant. We should be CHANGING our stock allocations in response to big price swings.


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