A few years back, I related a story about the comedian Joan Rivers. Her daughter, Melissa, likes to joke that her mother was always very consistent. Wherever she was, she would always drive at 40 miles per hour, whether it was on the highway, in a school zone or in the driveway.
This is funny, but it also illustrates a key challenge for investors. On the one hand, it’s important to be consistent. But at the same time, it’s important to be flexible, to adapt to new information or changing circumstances. There’s a fine line between consistency and stubbornness. For that reason, I believe investors should periodically reassess their thinking on key questions. Over the years, for example, my views on the following topics have changed:
Psychology. For many decades, the accepted wisdom in finance was that investors were rational, and that psychology played no part in financial decision-making. The investment establishment generally accepted a mathematical approach to investing called Modern Portfolio Theory. But that changed with the emergence of behavioral finance in the late-1970s. Investors today generally see math and psychology playing roughly equal roles in how markets operate.
I too have shared that view, but over time, I’ve come to think that math and psychology are not quite equal contributors. Today, I see psychology as the far more important driver of investor behavior. Math, I think, plays only a supporting role. You don’t need to look too far back to see why.
Recall 2020, when the stock market dropped 34% in a matter of weeks. That decline flew in the face of even the simplest financial analysis and could only be attributed to emotion. I recall hearing some investors at the time predicting a 1930s-style depression. But then, just a year later, we saw investor psychology drive the market in the opposite direction. The market rose far above its pre-Covid peak, as investors threw caution to the wind. Initial public offerings, crypto “currencies” and tech stocks all rose in a 1990s-style frenzy. There was little or no data underlying much of this behavior. As a result, in 2022, many of these highflying investments dropped 50%, 70% or more.
Wall Street analysts contribute to this dynamic in a subtle way. When a stock starts trading at a higher level, for example, they’ll sometimes call it out as being overpriced. But at other times, they’ll justify that higher price by declaring that the stock has been “re-rated” by investors. The re-rating refers to the stock’s price-to-earnings (P/E) ratio. When a P/E rises, it means that investors are willing to pay more for each dollar of corporate earnings, causing the share price to rise. The trouble, though, is that P/E ratios only appear quantitative. They don’t have any mathematical underpinnings. So when a stock’s P/E ratio rises, it’s really just another way of saying that investors like that stock better now. The upshot: Investment professionals, even when they’re trying to be rigorous, are often simply fitting their math to the prevailing psychology.
To be sure, math does play some part in how investment assets are valued. When bonds dropped last year, for example, it was directly related to—and largely proportional to—the Federal Reserve’s interest rate increases. But more often than not, the market seems to be driven more by emotion than by anything else.
If that’s the case, how can you navigate this with your own finances? One approach—and I’ll acknowledge that this may sound circular—is to simply recognize this as a reality. In other words, recognize that “the market” isn’t all-knowing, that it’s just a collection of individuals, each of whom might be making their own less-than-logical decisions. If you can see the market through that lens, it will be easier to tune out much of the day-to-day commentary, especially during periods of volatility.
Recency. Among all the psychological drivers of market behavior, fear and greed are the most commonly cited. That makes sense, but I’ve come to think about this differently. I used to see these as fixed personality traits. Some people tended more toward greed while others were more fearful. In my experience, though, many investors oscillate in their thinking about investments. Sometimes they’ll be more fearful, and at other times they’ll become more aggressive.
Why? Ultimately, I believe fear and greed—as well as many other emotions—are simply manifestations of the same underlying dynamic known as recency bias. That is the tendency to assume that recent trends—whether positive or negative—will continue into the future. Psychologists have identified dozens of different behavioral biases, but I’ve come to see recency bias as the most powerful among them. And for that reason, it’s the one that as investors we need to be most aware of, and most careful of.
Rational ignorance. Another market factor which I’ve come to appreciate more is the notion of rational ignorance. As investors, there’s simply too much information coming at us and not enough time in the day to process it all. As a result, it’s actually a rational decision to choose to ignore certain topics, even when they represent potential risks.
A few weeks ago, for example, I referenced the U.S. government’s 2019 “Worldwide Threat Assessment.” In that document, written well before the pandemic, the government wrote: “We assess that the United States and the world will remain vulnerable to the next flu pandemic or large scale outbreak of a contagious disease…” In other words, the coronavirus shouldn’t have surprised us, but it did. Why? I attribute it to rational ignorance. And while no one can see around corners, it’s why, in building financial plans, I encourage investors to consider risks that may, currently, seem unlikely.
Fundamentals. Even when investors do try to be rational, another fly in the ointment emerges: In investment markets, there is often more than one factor at play. Consider the inflation spike that started in 2021. Economic theory says that inflation should weaken a currency, but the dollar actually rose in value. Why? Even though the Federal Reserve was slow to respond to the inflation threat, other government programs at the time were driving our stock market higher, making the dollar more attractive to international investors. This is a big part of why it’s so hard to make economic predictions. An investor might correctly forecast one factor but overlook others.
Sometimes even the same fundamental factor can cut both ways. Rising interest rates, for example, have put a damper on home prices because they’ve made mortgages much more expensive. But prices haven’t dropped as much as they might have, owing to a more subtle, countervailing effect: Homeowners with existing low-rate mortgages are now more hesitant to move because that would require a new mortgage at a higher rate. This has resulted in fewer homes being put on the market, and that reduced supply has created upward pressure on prices. The bottom line: It’s important to be aware of current trends in the economy, but we should be careful not to base investment decisions on forecasts, even when we feel they are grounded in the evidence.
While I’ve changed my views on these topics, there are other principles that I feel even more strongly about today than I did in the past. I’ve argued that private funds are a very difficult way to make money for individual investors and still feel that way. Instead, I see simplicity as a critical pillar in building portfolios. Whether you have $30,000 or $30 million, I believe index funds are investors’ best bet, for their tax-efficiency and relative performance, among other reasons. I see active management in all of its forms—including stock-picking, market-timing and forecasting—as a fool’s errand. And I agree with fellow financial planner Peter Mallouk, who has argued that “somewhere between 99% and 100% of all cryptocurrencies are going to zero.” Because they lack intrinsic value, they’re unsuitable as investments. And because they’re volatile, they’re unsuitable as currencies.