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: The Effect of the Media Hype on Investors

Has the hype in the media over the last several months had an effect on how you invest in your retirement plan? The answer is most likely, yes. And the reason is the media presentation of investor news and nowhere is this done better than on television.

Thomas Schuster, who wrote the book "The Markets and The Media" suggests that television news has changed the way investor's react and eventually what they do. "Novices," he writes, "receive their basic training in investment issues via the media, even via such an improbable candidate as television."

Because the news is interested in only short-term events, Mr. Schuster worries that that sort of focus "provides explanations which afterwards evokes an impression of logic". There is unfortunately no way for even a savvy investor to parse that sort of information, see a developing trend that encompasses both the past and the recently reported story and make any sort of logical decision. But people do.

And the reason for this is pure coincidence. Sometimes your perception and the reality of what is happening meet and when they do, there is often a seismic shift in not only how you view your investment strategy but fundamental values as well.

There is no rational for this type of behavior short of we just do it. We treat stock information garnered from television, even stations devoted to the interactions of business and their shareholders/investors as if it were information worth having. There has been some speculation that the real traders understand this and seek to profit from this sort of non-knowledge.

It is as they say, much easier to swim with the tide. And many traders are now focused on doing just that, predicting when their colleagues, other investors all begin to believe something is worth more than they know it should be worth. The benefit these traders have is knowing that they are investing on emotion and because of their cold-hearted approach to the subject, bail long before the rest of the group realize what it is that they don't know.

So what do we do? The best thing would be to cancel cable and turn off the television. But that isn't going to happen. So the following three suggestions might help.

First: examine why you did what you did in the first place - you know, before you began to question those motives. Chances are you were probably right. If you used your retirement plan according to the time-honor, take-a-lot-of-risk-when-you-are-young method of investing, you probably should go back to that. That is, if you have changed. The most recent news has sent folks scurrying for the less risky forms of investments in their portfolio largely in part because of how the news portrayed the stock market's reaction the global financial crisis.

If you did, keep in mind that "the crisis" affected everyone, equally it seems. The second thing to remember is that you are not the only one with a damaged portfolio. If you managed to keep your job, weren't too deeply in debt and for all intents and purposes, are saving more, your approach to retirement should not have changed. Although the economy (even the global one) will not recover evenly, it will in fact recover with time. If you had spread your risk across four or five sectors (growth - large, mid-cap, small-cap, international and emerging markets) you would have covered all of your bases and be on the way to a decent recovery.

Third thing to remember is that this will take awhile. If you do not feel as though you have enough time I have bad news: investments take time and worse, take their own sweet time returning to normal. But as renowned economist and thinker John Kenneth Galbraith once suggested, the market has no memory. But you will often recall the pain of a loss much more vividly than the market does and this will keep you from making the correct investment decision when you are most emotional, which is often in the aftermath of some new piece of news.

If you have a short horizon, you need to either lengthen it or reevaluate what your plan intends to do for you if you do not allow it to recover before you start drawing down the assets.

Next up: The negative effects of optimism.

Why Investors Do What They Do: Regret

One of the basic assumptions in investing is risk. Risk is subject to a great deal of bad investor behavior and most notable of what occurs in an investor's mind is regret.

Regret is a math problem believe it or not and has long been discussed as component of statistical gathering. In her book "The Nature and Growth of Modern Mathematics" Edna Ernestine Kramer suggests that by using Professor Leonard Savage's regret matrix, something she defines as "the difference between the actual payoff" as a result of "some pure strategy and the payoff he might have received" had the test subject known for example, what could have happened.

As an integral part of decision theory, Savage's 1951 study of the subject was not the first. Blaise Pascal may have been when he proposed his wager. Nor was it the last. Investors have a tendency to look for benchmarks. Mutual funds use benchmarks to tout their investment prowess. And the probability that doing either of these exercises as being worthwhile is debatable.

Investing, no matter how lonely that decision you make seems, is always a competitive one. Failing to realize that your decision's success needs to have taken into account how other people doing the same thing is often commonplace. Yet, this is often not decided based on any specific thought. You see where other folks are investing. If they flock, you flock. If they flee, you flee. Human nature actually and genetically wired for survival. And you make the decision on how to allocate based on what you fear most: risk.

But our big brains get in the way. This is where regret comes into the picture. Savage constructed a criterion he called the Minimax Regret. We are at an investment point in time where we are (if not already have been) subject to regret in doses much larger than we have experienced before. These reactions and the rationale you may have used to make your decision was based on minimizing your risk for a situation that may well have passed.

This will result in a portfolio recovery period that will take you much longer to get back to even than someone who had not reacted or regretted their investment decisions. The market makers, those you placed your trust in, if blindly and unknowingly, made numerous wrong choices and everything fell in. The mutual funds that are used by you to achieve long-term gains have now repositioned their holdings to begin again in the aftermath of the last twelve months. Denying risk at this point (heading off to an index fund or worse, a target-dated fund) will not allow risk to play a role in your financial recovery.

Regret is a surprisingly destructive part of an investor's behaviors. Anticipating past history in making investment decisions allows regret (the "what if" is replaced with the "what if I don't") to strangle risk and not allow it to do the job it is supposed to do.

Next up: The media