Monday, July 13, 2009

Why Investors Do What They Do: Investor Optimism

A Recent Gallup poll tells it all. Well some of it anyway when they suggest: "The sharp decline in Gallup's Index of Investor Optimism in June -- particularly the plunge in expectations for the economy -- suggests that investors may be losing some of their hopes for an immediate improvement in the U.S. economy later this year." In the last in our series on why investors do what they do, we will examine optimism.

According to the Gallup website, the survey for "The Index of Investor Optimism results are based on questions asked of 1,000 or more investors over a three-day period each month." Although these individual snapshots can help us see where we were, only optimism propels us forward. Unfortunately, these looks back in time have an effect on how we make future moves.

While we may see it as a screenshot of how we invest, the real hidden knowledge behind the poll is consumer spending. Asking questions such as whether you will be able to achieve your investment targets over the next twelve months requires you to know what those goals were over the previous twelve months and during that period, you switched gears (and how many times). The thousand who were surveyed were also asked to project those hopes and fears into the future five years from now.

Key to achieving any sort of optimism when it comes to investing is job security. With one in ten Americas out of work (a number that is without a doubt, much higher due to the lack of jobs for those entering the workforce for the first time and unable to collect benefits and for those who are disparaged and no longer receiving any assistance), stability of income and the potential for raises play a significant role in how we look ahead. Bernard Baumohl in his 2007 book "The Secrets of Economic Indicators" calls the poll not only intriguing "it measures the attitude of private investors" yet it "also happens to the one of the least known."

Optimism is a mood, a feeling that offers us hope. Richard L. Peterson author of "Inside the Investor's Brain" writes that "investor optimism about the stock market's future declined in tandem with prices". He continues by suggesting "intellectual assessment ("overvalued") is decoupled from their underlying feeling of optimism ("it's going up")."

In an essay written in 1903, titled Optimism, Helen Keller calls optimism "the proper end of all earthly enterprise. The will to be happy animates the philosopher, the prince and the chimney sweep." And while I don't want to throw water on those thoughts, optimism has a dark side when it comes to our investment behavior. Coupled with all of the investor behaviors we have previously discussed here, optimism can wreck the most havoc to a long-range portfolio, in particular one built to grow for retirement.

Morningstar recently reported that "Diversified Emerging Market funds benefited from a $4.9 billion inflow vs. a net outflow of $2.6 billion in 2008." Emerging markets will always be the quickest to recover in part because of their bargain basement prices and one of the few places where risk remains risky. In a previous month's post, I warned about some of these problems and how emerging market mutual funds might not all be full of stocks from countries that are actually emerging.

Optimistic investors have also begun to channel money into more riskier bond plays "Junk bond inflows have increased $12.6 billion in 2009 vs. a rise of $1.2 billion in 2008" and Morningstar also reported that "Investors have piled in $7.8 billion into natural resources and precious metals funds after withdrawing $2.1 billion from the same category in 2008."

Chasing returns, at least past returns is also part of the problematic herd mentality and feed directly on optimism. Pessimism, which every knows is the opposite of our topic, also gives investors a sense of needing to follow what other investors do.

Optimism will not ride the coattails of this recovery. Instead, any recovery will be the result of it.

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