Why Being 'Rational' Usually Fails When Making Investment Decisions

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Includes: VFINX
by: Tom Madell
Summary

Investors, or those pondering becoming so, will almost always base their decisions on a rational appraisal of possible outcomes.

But does a rationally based appraisal of presumably relevant facts always lead to the best outcome?

Unfortunately, in spite of the wide acceptance of rational data as the basis for predicting investing outcomes, such data too often fails and is probably useless.

Investment performance is inherently unpredictable, but it is likely more fruitful to seek out psychological reasons for what will come next rather than economically related ones.

Without wanting to sound presumptuous, this may be the most unusual investment article you are likely to ever read. Why? Because it likely goes against everything about investing you may have ever considered.

The article consists of two related parts. The first part deals with deciding whether or not to invest at all. The second part tries to shed some light on making more specific buy/sell decisions. In both cases, I argue that using apparently reasonable and logical information to help make investment decisions may not turn out favorably. Feel free to skip the first part if you are already committed to a long-term program of investing.

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Should I Invest at All?

I like to think of myself as a rational person (although doesn't nearly everyone?). That means I try to gather and utilize relevant, and hopefully, forward-looking information when deciding on a course of action. To fail to do so should mean that only luck will most likely determine whether or not my choices turn out successfully.

So it would seem that a similar rational approach should be helpful in deciding whether or not to engage in mutual fund or ETF investing.

Let's use myself as a prime example. It took me many, many years to buy my first mutual fund investment. Why? Too risky, I reasoned. History tells us that stocks (and bonds) will go up and down. But in attempting to avoid the downside, I, like many others I'm sure, was willing to forego the potential upside.

We all know, I'm sure, many individuals who never attempt to invest for fear of losses, or swore it off after having got burned or witnessing an excess of stomach-churning volatility. This is in spite of stocks' long-term history of advances over the long haul and ability to make up for losses over ensuing relatively shorter periods. Instead, for these individuals, the decision is usually to place any excess savings in low interest bearing bank accounts, CDs, money market accounts, or such. Such decisions, when compounded over the years, can represent a huge loss of wealth-generating potential. But going from near-zero risk to having true investments and remaining in them obviously isn't the right decision for everybody.

I myself remain wary of buying a lottery ticket, race track betting, or casino gambling for the identical reason: I want to avoid losing money. But if one "rationally" thinks of investing as similar to making such bets, which many people seem to believe, they likely have not analyzed all the facts. In reality, such activities, all of which are attempting to "grow" money with an uncertain outcome, while in some ways might seem similar to investing, are vastly different.

In making bets, the odds greatly favor "the house," meaning over an extended time, you are almost guaranteed to lose money. In investing, however, unless you are paying exorbitant fees (which, I should add, is completely unnecessary) and/or investing in only a few highly undiversified stocks, the odds greatly favor long-term success.

In what other endeavor can you simply put down a set amount of money and by merely waiting (that is, historically speaking), receive a return far in excess of your initial outlay? For example, if you had invested in the Vanguard 500 Index (VFINX) when it first became available in 1976 and just did nothing the following approximately 43 years, your average annualized return over the period would have been about 11%. (Of course, there would have been some periods when returns were negative, such as the extended periods between 2000 and 2002 and 2007 and 2009, but for the investor who could afford to merely wait it out, positive returns eventually proved to have made the wait highly worthwhile.)

So when are the times in one's life that it would truly be unwise to invest? These would be when we cannot afford the possibility of relatively shorter-term losses, even if those losses would have eventually been proven to have been overcome through the passage of time.

People with a small nest egg may need the security of what they've got in case unforeseen expenses arise. People saving for a specific goal coming up in a short time, such as a child's education, can't risk coming up short when the bills starting hitting. Many could be said to be living paycheck-to-paycheck and therefore have little or no extra to invest. Or, the elderly may not want to roll the dice; they require a certain amount to live on and certainly no less. Gaining more is not a risk they can afford. These are just some examples where investing might not make sense at all.

But even after eliminating these types of situations, there is probably a bigger majority who could invest but simply choose not to. Many of those who would say they have too little to spare for investing could probably eliminate some unnecessary spending and instead gradually set aside a little to invest. (Of course, in our "consumer-oriented" culture, excessive spending can be a big obstacle preventing saving for a rainy day.)

So here's my point: My guess is a majority of the population are failing to consider what their lives may be like without enough money for retirement. According to a recent article, one in three of us have saved less than $5,000 for retirement.

But just saving for retirement may not be enough to avoid poverty; another article states that according to recent research, some 40 percent of middle-class Americans are at risk of poverty in retirement. If mere savings, as described above, fail to grow much above inflation, most savers are close to just standing still with their money. Thus, while it may appear rational to avoid investing as too risky and complicated, it would seem that far too many people are making the wrong decision about how they allocate their resources while money is still coming in before retirement.

As I said earlier, in my own case, fear of losses played a big role. Another factor I suspect that strongly affects decisions not to invest is it takes a little time (but not really a lot of knowledge) while seemingly needing to delve into an area where virtually nobody, even experts, has all the answers.

Should I Buy More, Sell, or Exchange?

The above are some of my thoughts on what I consider opportunities missed to participate in one of the best ways to improve one's financial future, not necessarily in a year or two, or even three, but more likely, many years down the road. But, so far, all I have talked about is decisions to either invest or not to invest. Now, I'd like to focus on why being "rational" may not lead to the best decisions of a somewhat different sort, when evaluating your options once you have already decided to invest. In other words, should you, at certain junctures, buy more, sell, or possibly exchange from an existing investment to a more "promising" one?

Getting back to my own case, and observation of most others, I believe we use information gathered from newspapers and the media, government reported economic data, and from commentary and advice provided by "experts" to help evaluate whether one should continue to hold existing investments, or perhaps sell or exchange them. Coupled with these, many also rely on their own "intuition" as to where the stock market is heading. The question becomes: How effective are any of these "insights" in arriving at correct decisions as measured by better results (or avoidance of losses) down the road?

My answer in a nutshell: Hardly at all! This is why it is so hard for even professional fund and money managers to "beat the market." All of these resources are based on the assumption that investing success or avoidance of losses is based on a "rational" appraisal as to what will happen next. (Remember all the tales of people who wound up losing a great deal because they sold in the midst of the 2000-2002 or 2007-2009 bear markets? Almost all would have done better by ignoring all the negative inputs at the time and just holding on.)

Almost all investors are guided in making investment decisions through what appear to be sensible ways to make intelligent choices regarding their investments. After all, investing is generally perceived to be closely tied to the presumably scientific field of economics. However, after many years of data watching, I have come to conclude that success in managing one's investments typically bears little relationship to seemingly intelligent thought processes suggested by mostly data-based analyses.

Stock market action, so far this year at least, provides a good example. "Rational" data starting from the beginning of the year has suggested that growth is slowing down, company earnings are going to be negative as compared to last year, and the chances of a recession in the next year or two have risen. Even the Federal Reserve seems to be telling us there may be more reason to be concerned about global growth than last year and has completely reversed its predictions of the economy's path over just a one month interval between Dec. 2018 and Jan. 2019. Yet, the stock market is off to one of its best starts to a year ever! If one had seriously weighed what all these inputs almost universally would have suggested, they might have sold off some (or all) of their stocks. In fact, fund investors have been doing just that, according to fund flow data, so far to their disadvantage. But ignoring the market chatter, including the Fed's flip flop statements, and just doing nothing, would have been the more successful strategy than acting "rationally" upon it.

Why should there be such a big disconnect or no relationship at all between rational data and stock market performance is anyone's guess. Perhaps the "experts" can readily come up with explanations, but almost always after the fact. Their ability to successfully predict what would happen next was wrong more often than not.

To me, the main explanation is that there is always very little, if any, relationship (or even a negative relationship) between economic data issued at one point and stock market performance for many months, if not years, ahead. If so, there must be something else more important than "clear" and "logical" (i.e. "rational") thinking determining the market's future performance.

So what does exert a much greater influence on the stock market's performance? If it's not economically-related factors, what's left is how people feel, in other words, psychologically-induced factors. A 10 year long bull market has probably swayed the biggest institutional investors (although probably not the "little" guy) that there's still opportunity for money to be made in the market.

In other words, the stock market turns on thoughts and feelings that cannot be readily measured, and certainly not predicted in advance. That is why outcomes are often directly the opposite of what common sense and rational thinking might suggest at any given time. Unfortunately, therefore, I would suggest it is nearly impossible and mostly a wasted effort to try to "intuit" how the stock market will perform based on "insights" provided by any or all of the above commonly used resources. Maybe that is why buy and hold has been working so well lately.

So my advice is this: Forget about trying to figure out the market in rational terms. Current trends and momentum, both psychological forces, can keep the market doing its thing, regardless of what the data or experts predict. However, although unpredictable, once the market's direction turns negative, the psychological forces will suggest possibly listening a bit more to any continued negative data.

Disclosure: I am/we are long VFINX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.