We All Make Irrational Decisions But That May Not Be a Bad Thing

Catalyst Stocks Premium Stock Pick Service

Machine Learning for Stock Selection

Get Instant Access

The perfect is the enemy of the good.

I write a lot about rational investing. But none of us is completely rational. We trade too much. We chase hot funds. We take a flier on dubious stocks. And, more often than not, we end up hurting our performance.

But I am unwilling to dismiss this behavior as mere foolishness. Why not? Seemingly foolish behavior can help us with our struggle.

Saving Ourselves

When saving for financial goals, we are supposed to figure out how much each goal will cost, make a reasonable estimate of what return we are likely to earn and then diligently save the appropriate sum every month.

Sound like the way you go about saving money? Me neither. Saving is a messy business, because of the constant temptation to spend.

To compensate for our lack of self-control, we often fall back on mental games. For instance, we might have a chunk of cash sitting in a money-market fund earning 1%, which we have earmarked for our toddler's college education. But right now, we need a new car.

Financially, it would make sense to "borrow" from the college fund and then pay the money back. But instead, we take out a car loan, even though the loan will likely cost us far more than we are earning on the money-market fund.

Why do we go this route? Mentally, we have earmarked the money-market fund for the kid's college education, and we don't trust ourselves to replenish the account if we dip into it.

"Lots of us know that we won't make those payments to ourselves," says John Nofsinger, author of "Investment Madness" and a finance professor at Washington State University in Pullman, Wash. "Mental accounting helps us stay disciplined."

Winning by Losing

The evidence is undeniable: Market-tracking index funds outperform actively managed stock funds. Despite this lackluster performance, actively managed funds still account for 91% of all stock-fund assets. Why do we continue to bank so heavily on a losing proposition?

It seems we like having the chance, however slim, to beat the market. In fact, it makes us more inclined to invest in stocks. We also find it comforting when professional stock pickers watch over our money. Their oversight gives us added confidence in our strategy and makes us more tenacious during rough markets.

To be sure, all this is likely to cost us, with the price paid in market-lagging performance. But when we suffer this performance penalty, maybe we are getting our money's worth.

Seeking Solace

Studies suggest you won't beat the market by following the advice of newsletter writers and stock analysts.

Yet, as we try to summon the nerve necessary to buy individual stocks, we often latch onto the recommendations of these experts.

Are we misguided? Maybe not. "Even if the stocks don't turn out to be better than other stocks, at least it gives us the courage to get started," Prof. Nofsinger notes.

Injecting Fun

While many investors struggle to find the courage to buy stocks, some folks have too much confidence. These investment junkies buy and sell stocks like crazy, thereby incurring exorbitant trading costs and taking unnecessary risks.

Still, such enthusiasm isn't all bad. After all, if we are enthused about investing, we are probably more keenly aware of how much money we need for retirement and thus we are more likely to save enough.

The trick is to make sure our enthusiasm for trading doesn't do too much damage.

"If you must trade and invest in foolish stocks, allocate $10,000 or 5% of your money, whichever is smaller, to a fun-money account," suggests Meir Stat-man, a finance professor at Santa Clara University in California. "And then, very much like in Vegas, try to make the money last as long as possible."

Playing the Percentages

We should all decide what portion of our portfolio we want in stocks and then stick with this percentage through thick and thin. But as many folks have discovered, this advice can be tough to follow.

Inevitably, some investors get skittish, and start dancing in and out of the stock market. This isn't a smart strategy. But it will probably lead to better results than simply leaving everything in a money-market fund.

SOURCE: Jonathan Clements, "We All Make Irrational Decisions, But That May Not Be a Bad Thing." Abridged from The Wall Street Journal online, March 26, 2002.

Part SIX Active Investment Management

In sum, while economic theory relies on rational expectations and rational behavior, be-haviorists have documented evidence and explanations of fundamentals of behavior that are inconsistent with this theory. However, the test of success of the efforts of the behaviorists is in explaining deviations of assets prices from predictions of classic theory. In the next section we provide an assessment of these efforts.

It is natural for behaviorists to concentrate on documented anomalies in asset prices and attempt to explain them by behavior that is excluded by economic theory. Here are the mainstream of these anomalies and offered explanations.

Was this article helpful?

0 0
Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

Get My Free Ebook

Post a comment