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Are you a "normally behaved" investor?

Behavioral finance experts have long known that strong emotions around money can cause normal investors to make errors – often systematically and to their detriment over time. Currently, we are in a period of higher than normal volatility caused in part by uncertainty around how global creditor and debtor nation trade imbalances (and the resulting debt levels that accumulate) will be reduced over time. In addition, slow U.S. GDP growth, a high unemployment rate and concern about the fractious U.S. political conversation over the debt ceiling have led investors to the perception that the U.S. will have trouble in implementing policies that can jumpstart growth in the short term and create a sustainable long-term growth and debt path. In this fearful climate, what insights do behavioral finance experts have to share with us?

I recently participated in a group conversation on this issue with Dr. Meir Statman, Ph.D., Professor of Finance at the Leavey School of Business at Santa Clara University, who is a widely acclaimed expert in behavioral finance issues. Dr. Statman pointed out that investors are human beings that yearn to be rich, want to find investments that have an oversized dose of "return" combined with an undersized dose of "risk," and want to make investments that have a certain level of cachet (even if those might not be the best ones). These "normal" human beings are prone to commit cognitive errors, caused largely by their emotions. For example, they procrastinate in the face of fear and uncertainty. They have a frame of reference that ignores the fact that there are intelligent investors on the other side of every security trade or portfolio re-allocation. They fear loss more than realizing a gain and base decisions on patterns they "see" in inadequate data. I found many of the ideas apropos and want to share a couple with you.

The fear of how you might feel later about your investments can be debilitating. One cannot know what growth-oriented assets such as equities, real estate and alternatives will do over the next few years as their volatility makes short-term prediction nearly impossible. Therefore, investors should almost proceed with caution – in parts and over time. This effectively dollar cost averages into the growth-oriented weightings in your portfolio.

Investors also easily come to believe they actually "knew" that something was going to happen after they have benefited from hindsight. For example, early in 2008 – many people felt that something "bad" might be on the horizon, but there were smart people on both sides of the issue – and it wasn't clear what actions to take leading up to the financial crisis. Stocks might have gone down, but from the perspective at that time, it was not clear that they would. After the financial crisis unfolded; however, some people felt a high degree of regret for not having seen things coming – even though it was really impossible to know in advance how the crisis would unfold. An even more destructive cognitive error is to come to believe that you actually did know what to do in advance – a result that can lead to overconfidence.

Normal human investors can also make cognitive errors when they base decisions on inadequate data, for example the recent past. They might shift into new securities or asset classes that purport to offer more return for less risk, or they may reallocate their portfolio into a mix of assets that has produced good results over the past few years. This kind of reliance on recent events can lead to poor going-forward results. An excellent tool to help prevent this kind of mistake is adopting an investment policy statement.

Another effective way to avoid overweighting the importance of recent events is to widen your frame. To do this, think about your total financial picture, including all of the resources you have at your disposal (e.g. your investment portfolio, your guaranteed retirement income benefits, and other resources such as your business, earning potential and the value of real estate holdings). Instead of paying too much attention to any particular asset, periodically judge how your entire financial picture has changed over the past 5 or 10 years to serve your long-term goals. Looking at your complete financial picture from this wider frame tends to filter what is happening right now and provides a structure for avoiding an unwarranted bias towards recent events.

For example, consider your entire, balanced investment portfolio when making judgments about how well things are going - don't focus on specific securities or performance in specific years. Consider the example that one balanced strategy, utilizing a mix of indices comprised of 40% defensive-oriented assets (fixed income) and 60% growth assets (globally diversified stocks, tilted to value and small companies plus some exposure to real estate) returned nearly 6% annually during the challenging 5 year period ending December 31, 2010. This may be disappointing performance given that the same portfolio had double digit returns annually since 1973, but it is hardly a disaster. It is far more effective to judge from the perspective of how this particular progress is supporting your actual long-term plans.

Finally, consider that even if the going-forward economic and financial environment is significantly different than the past few decades (again, impossible to know in advance), it does not necessarily follow that a different investing discipline is required. I believe that the time honored approach of appropriately diversifying your portfolio with asset classes that are not perfectly correlated is still the best way to provide you with a good, long-term investment experience.