Don’t let basic instincts drive investor behavior

September 12, 2013 Categories: Portfolio Corner
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For investors, one major challenge to success comes when their instincts, hardwired into human behavior for millennia, can push them to make the exact wrong decisions.

Take the fight or flight response. It’s served humans pretty well for the past few thousand years, but when it comes to investing, the desire to fight or flee at the first sign of trouble often does more harm than good.

In these situations, the investor suffers from a “lizard brain” problem. The Amygdala is the section of the brain responsible for survival; so named the ‘lizard brain’ as this area of our brain evolved a long time ago, back when our primal lizard-ish concerns were much more prevalent.

And lizard brain behavior goes something like this: investors feel threatened by a downdraft in the markets or a negative news cycle, and the fight or flight response kicks in. Since they can’t fight the market, they flee, pulling out of equities and into cash, and wait around for things to get better. Of course, by the time things look better, the investor might have missed the recovery.

On the flipside, people want to invest in things that are doing well, and are only more confident when an investment has been doing well for a while. But what happens if they buy in just as the market cycle changes? An attractive investment can end up underperforming.

This chart succinctly demonstrates the issue. The gray line represents the market, while the bars represent flows into and out of bond, equity, and hybrid mutual funds. As you can see, in their desire for safety, investors may end up buying high and selling low. The instincts of the lizard brain can lead directly to a negative outcome.

Don't let basic instincts drive investor behavior

Source: Industry flows – www.ici.org/research/stats; Russell 1000 Index; ^According to ICI, “hybrid” funds invest in a mix of equities and fixed-income securities; *industry flow data for January 2013 is an ICI estimate through 1/23/2013 based on reporting from 95% of industry assets. Data shown is historical and not an indicator of future results.

A companion issue stems from people’s fascination with patterns. Humans have the ability and the desire to recognize patterns, even if they’re just coincidences.  Pattern recognition is what allows an investor to say “this time, it’s different” when reacting to down markets. The problem is, “this time” is rarely different.

What does this all mean?

In a nutshell, successful investing is hard. It’s hard for a lot of reasons—markets are complicated, most investors need to commit to risky assets to potentially generate the returns they need—and our wiring doesn’t help. To succeed, investors need to learn to ignore many of their instincts and focus on the long term. Russell’s new Successful Investing is Hard video series may be a helpful resource for your clients, reinforcing the fact that in order to be successful in investing, investors need to resist their natural instincts.

The bottom line

Create context for your clients

Clients looking to meet their real goals often need to put their money in risky investments to potentially generate adequate returns. Timing the market is difficult, and missing even a few strong performing days can significantly impact the value of a portfolio. As a result, clients should focus on staying invested in a way that meets their goals and their risk tolerance.

The Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000® Index, representative of the U.S. large capitalization securities market.

Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

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