Chapter 9: Know Thyself

One of the most important things that any investor can do is identify their risk tolerance. You should understand how recent market activity may influence the way you feel toward the market, and consequently, your risk tolerance at any given time.
I have followed Jason Zweig for many years and have always found him to be a voice of reason. Your Money and Your Brain by Jason Zweig, Simon & Shuster, should be required reading for all investors. The following article appeared in the Wall Street Journal in February 2012. If you do not read Jason’s book, at least read this article.

The Intelligent Investor: This Is Your Brain on a Hot Streak by Jason Zweig

Past returns are no guarantee of future success. Just like smokers ignoring the Surgeon General’s warning on the side of cigarette packs, investors over-look the most obvious caution about the stock market at their peril.

Even after Friday’s stumble over renewed fears about Europe, the Standard & Poor’s 500-stock index has gained 7% so far this year, and the Russell 2000 small-stock index is up 11%.

Why is it so hard for investors to regard such short-term hot streaks with the cold eye they deserve?

Decision Research, a nonprofit think tank in Eugene, Ore., has conducted a nationwide online survey of investors seven times since 2008. These surveys have shown that investors’ forecasts of future returns go up after the market has risen and down after it has fallen.

William Burns, an analyst at Decision Research, says investors’ forecasts of the market’s return over the coming year were heavily swayed by how stocks performed in the previous month.

They might not have had a choice. The investing mind comes with built-in machinery that sizes up the future based on a surprisingly short sample of the past. Neuroscientists say the human brain probably evolved this response in a simple environment in which the cues to basic payoffs like food and shelter changed slowly and rarely, making the latest signals most valuable —nothing like what today’s investors face with electronic markets in a constant state of flux. Experiments led by neuroscientist Paul Glimcher of New York University found that cells deep in the brain calculate a sort of moving average of past events, giving the greatest weight to the most recent outcomes.

When the latest rewards turn out to be better than the long-term pattern, these neurons fire unusually quickly, spreading a burst of dopamine—the neurotransmitter that triggers the pursuit of reward—throughout the brain. Thus, after a decade of mostly dismal stock returns, even a month or two of outperformance might prompt you into an impulsive plunge back toward stocks. Some investors seem to have learned how to resist this tendency, and you should, too.

Charles Manski, an economist at Northwestern University, has analyzed how people form expectations of what the stock market will do next. Based on nationwide surveys of households conducted from 1999 through 2004, he has identified three main types of amateur forecasters.

Just over 40%—the largest group—believe recent performance is likely to persist. Another third of investors think recent returns are likely to reverse. Finally, roughly one-quarter of people think returns are random and essentially unpredictable.

Stock market volatility is a significant retirement concern. Volatility may cause some investors to allow emotion to affect their decision-making, resulting in losses that are difficult to make up, especially in retirement or nearing retirement. For example:
• A 20 percent loss requires a 25 percent gain to recover
• A 30 percent loss requires a 43 percent gain to recover
• A 50 percent loss requires a 100 percent gain to recover

Have a question? Contact Ed Mahaffy.

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