Cycles of Dumb: Week Two

By Gary Silverman, CFP®

Last week I introduced you to my concept of dumb: Namely the tendency for really smart people to do dumb things with their investment portfolios. I gave you an example of one of my former clients who couldn’t hold back putting his money into a hot market. Then, once the stock market started dropping and then continued heading down, fear began growing in his gut and spread. He succumbed to the fear and ordered everything sold.

It was a dysfunctional cycle that is very familiar to any veteran adviser. It, much more than the gyration of the markets, is what keeps us up at night. Markets eventually recover. Some client actions can keep their portfolios from doing so.

Before I go further into this, I don’t want you to think that I’m saying the way to riches is hiring an adviser. Just because an adviser can keep a client from doing something dumb in the portfolio, there is no guarantee. A client might choose not to take the adviser’s advice. Why would a person hire an adviser and then ignore them? It happens a lot more often than you might think. But there’s another reason as to why a client’s portfolio has something dumb happen to it—the adviser is the one messing up. Advisers are, after all, humans. As such, they can also get giddy and euphoric or fearful and panicky at the wrong times.

Allow me to describe a full market cycle that shows just what is going on with our brains that causes most dumb actions. In the mid-90s, the market was in a bull phase, but most were not too convinced. After all, they’d recently been through the lost decade of the 70s, the ‘87 crash, the 1990 mini-crash, and 1994 when everything (including bonds) stalled. No, for the vast majority of Americans stocks were not the place to be. But that started to change a bit…somewhat accidentally. You see, a number of retirees in the late 70s and early 80s had based their retirement on double-digit returns on their bank CDs. Most locked in rates for 10 years. When the maturity date rolled around interest rates had fallen dramatically and the new income stream being guaranteed by banks were one-quarter to one-third of what they were used to. Imagine having to tighten your budget that much.

So the retirees, looking for a replacement, found it in stock mutual funds. If going from safe secure bank CDs to stock mutual funds seems a bit drastic, you’re right. But a lot didn’t actually understand what they were getting into. All they knew is that these funds had been returning more than even their old CDs were. That they could also lose money didn’t register in their heads.

This is what behavioral finance experts call Recency Bias. It means that folks believe that what’s been happening recently is extrapolated far into the future. In this case, people believed that the stock fund which had done well the previous year would continue to go up indefinitely.

We’ll continue our look at Recency Bias and other causes of over confidence in the markets next week.

This article was published in the Wichita Falls Times Record News On August 28, 2016.