New Year's resolutions for irrational investorsTen ways to win an unpredictable game playing with a huge handicap
By Paul B. Farrell, CBS MarketWatch
Last Update: 12:03 AM ET Dec 31, 2006
ARROYO GRANDE, Calif. (MarketWatch) -- Last year our readers worried about a meltdown. Wall Street's gurus merely underestimated, with an 8% prediction. The market went up 15%. This year the guessing game has gurus predicting no recession and a bull running for a fifth year.Will it go up 15% again in 2007? Maybe. Maybe not. The S&P 500 has averaged roughly 11% annually since 1926. Half the time above 15%. Half the time below, including under 5% a third of the time. Equally significant, most of the time the guessers are way off the mark, either way high or way low.
They're unreliable, and yet every year at this time hungry journalists take advantage of a gullible public that desperately wants a dollop of hope and certainty, even if both are quickly forgotten within days, if not hours after the ball drops in Times Square.
This year, however, the optimism is perhaps noticeably more intense as Wall Street and Corporate America's leaders luxuriate in huge 2006 bonuses, praying that 2007 will bring more of the same. And, predictably, their in-house economists feed their wishful thinking with upbeat 2007projections all over the press.
But buried on the back pages, you'll see the wealthy aren't upbeat. For example, a recent American Affluence Research Center survey tells us the richest 10% of Americans are pessimistic about 2007. And as the masses have already discovered, economic rewards have not trickled down very far if you look at the low long-term investor returns, as inflation eats up meager income gains of average workers.
Then there's the housing market, that 800-pound gorilla sitting in the living room, which everyone hopes will quietly exit the back door in 2007. Unfortunately, despite some favorable year-end data, the housing industry will probably drop a lot further, hurting 2007 markets. For example, in the Christmas Day editions of both Forbes (Jim Grant's column) and Business Week (Peter Coy's column) we're warned against the "oft-heard assertions that the worst is over." Wishful thinking won't make this problem go away.
So, how can you win in 2007? If you're one of America's 94 million passive investors, we got 10 resolutions to live by:
1. OK, say it out loud: 'I am an irrational investor!'
Yes, we all want to appear rational, logical, objective. To please parents, spouses and bosses. So we fake it. And we also want to live up to Wall Street's historic ideal of the "rational investor."
But the truth is, even with today's information-overload we never have enough. Most of the time we wing it, investing with our fingers crossed. Neuro-finance research is clear: Investors are unquestionably irrational. In addition, we really don't trust Wall Street. We love being in charge, having fun, making our own decisions.
2. Yes, I know I'm running a handicap race against Street pros
Behavioral finance experts comparing the performance of Main Street investors against professional managers tell us that it is virtually impossible for Main Street to beat the pros for two reasons: Pros have a competitive advantage, with tons of fancy analytical, database, timing, tax and regulatory tools. And professional managers play the game full-time, every day, all year, making $400,000 annual incentives and bonuses, about 10-times the average Main Street investor. You're playing with a huge handicap.
3. I will never again try to predict our unpredictable markets
Markets are inherently unpredictable, ruled by unruly mobs of irrational investors. In 2007 I will listen to the warnings of Wharton Prof. Jeremy Siegel, author of "Stocks for the Long Run." He studied all the big market moves between 1801 to 2001, and discovered that 75% of the time there was no rational explanation for major moves up or down in stock prices.
4. Yes, I'll be optimistic about my life, but not the market
Optimism is essential to success in sports and the military, for corporate executives and entrepreneurs. But optimism kills stock market returns. Behavioral finance experts tell us overoptimism is the investor's single biggest saboteur, the reason we underperform the market, often returning less than inflation. Optimism gives investors a big ego; they believe they know more than they do, overestimate their skills, underestimate risks, see trends and patterns that don't exist, then make costly mistakes.
5. I will focus on the long term and stop active trading
Neuroinvesting studies compared the performance of traders in America and Asia. Both underperformed by significant amounts. One studied 66,400 Wall Street accounts over seven years. Active investors turned over their portfolios 258% annually, and made 12% on their money. Passive investors with only 2% portfolio turnover gained 18%, a huge advantage. Another studied all active traders on the Taiwan exchange. Different cultures, same results. Why? The more you trade the less you earn. Transaction costs and taxes kill returns.
6. I resolve to live 'below my means,' saving 10% for retirement
One of the great truths "millionaires-next-door" learned is that living "below-your-means" builds wealth and retirement nest eggs, and makes the trip more fun. In short, the "future is now," you don't need a million bucks to start enjoying it. Remember, if you're not saving at least 10% of what you're making, you are spending too much! Commit this formula to memory: Nothing saved equals nothing invested and nothing to compound, and that equals an uncomfortable retirement tomorrow.
7. I resolve to trust nothing I read in the media
Irrational exuberance and overoptimism are like wildfires, feeding on themselves. Wall Street's spinmeisters understand this. That knowledge makes the media a powerful tool in the manipulation of naïve, vulnerable investors.
Remember, Wall Street's huge bonuses came out of the returns of Main Street investors, which have barely averaged 1% annually in the seven years since the 2000 peak. And never forget how the market lost $8 trillion in 2000-2002 in spite of Wall Street's happy-talk.
8. OK, I know my broker's advice is always biased in his favor
The advice of every broker is tainted with an inherent conflict of interest. As a result, their personal self-interest comes ahead of my interests. And I know that if I really want to build a nice retirement nest egg, I must accept this reality and think for myself. So I will take responsibility for my financial health, my portfolio, my future. A fee-only adviser is a better alternative.
9. I promise I will build a well-diversified portfolio
Nobel economists tell us that active trading is not the best investment strategy. Rather, focus on a well-balanced portfolio diversified across multiple asset classes.
We also know Wall Street gives only lip service to this strategy. Instead, their hype machine annually floods us with over 40,000 ads recommending roughly 18,000 funds and 10,000 stocks, even though they also know that a mere dozen or so funds is all you need. The Nobel strategy works, I will use it.
10. In 2007 and beyond, I will only buy no-load index funds
Ride the indexes. With just 10 index funds you can buy into virtually all stocks traded on the exchanges. Consider this question: If you don't need more than 10 funds to capture the entire market, why is over 90% of America's $10 trillion mutual fund market invested in higher cost, lower return actively-managed funds? Answer: Because the financial industry can siphon off more of your money that way, and their brainwashing machine is incredibly effective at misleading Main Street investors into believing the lie that active management strategies beat indexing. Not true: Between 75% and 85% of actively managed funds fail to beat the indexes.
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