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.

Why Investors Do What They Do: Herding

It is okay to look at the winners and losers, for mutual funds they are posted quarterly while stocks are posted daily. It is also okay to want to align yourself with the winners while foregoing the losers. It is only called herding when the winners see a large influx of new investors because of past performance, an indicator that is usually disclaimed as not indicative of future results. But the actual act of buying into any investment with the hope that the current top is not actually a top but a lower rung on an ever-rising ladder.

The cautionary warnings about just such a strategy often fall on deaf ears. Few folks have the patience to wait out an investment that has performed well in the hope that if they shift their investment to a high-flying fund, they will do even better. There are several things to consider before doing this and lessons to be learned if you have ever done something like this.

First off, funds that maintain a steady amount of growth usually take all of the cost factors into consideration. Among those factors, turnover stands out. Many high flying funds that find themselves on the top ten lists, at least in the short-term, usually have very high turnover - which means, higher than average trading costs, a new manager that has shifted priorities or simply a manager rearranging where they are as the quarter or year ended. Turnover incurs trading costs that are directly passed down to the shareholder. Sometimes, they even create a taxable event if the fund has sold numerous winners from the portfolio to reposition the fund for another round of winning.

Those steady growth funds are often referred to as value funds. Value funds tend to look for undervalued, better performing companies. Growth funds, which dominate the marketplace, tend to look for companies that have more potential than proof of success. This leads to a higher underlying risk and increased turnover risk. While they may actually grow in value, these types of funds often undercut those profit numbers with higher than average fees.

Secondly, mutual fund investors often fail to consider the size of the fund or the size of the companies that the fund invests in. While there are thousands of companies to chose from, the majority of these companies are actually much smaller, more volatile because of their size and although they offer growth, they seldom have the long-term track record to prove investment-worthy.

And lastly, investors who herd seldom take into account the geographic area of those underlying investments. While the world faces the same economic challenges, the recovery will vary from one region to the next. Some parts of the global economy may recover more quickly (such as emerging markets) while more industrialized nations such as the US will take longer to embrace the economy recovery.

In Emilio Barucci's book "Financial Markets Theory" he describes herding as an "effect [that] arises because other decision makers may have information important for the decision maker". He points out that "fund managers care for their performance because their compensation, their career and the probability of being chosen in the future by investors depend on their performance relative to an exogenous benchmark or to the performance of other fund managers." He notes that the presences of these features, while not saying competition is bad, results in investor herding.

It should also be noted (and this comes as a warning as well) that herding is most prevalent after a crisis. But herding is usually based on a weaker set of reporting requirements, opaque regulations, somewhat lower accounting standards, reputation and most importantly, potential. Alan Lewis wrote in his 2008 book "The Cambridge Handbook of Psychology and Economic Behaviour that there is absence of knowledge on the subject when it comes to long-term results or opportunity suggesting that there are "deeper, structural underpinnings of investor behaviour [sic], including their investment beliefs and the way investors justify their behaviours to others."

Next up: Regret