“The three worst words of stock market advice: Trust Your Gut.” That was the headline of a recent article by Jason Zweig in The Wall Street Journal, reporting on a new academic study. Dr. Robert Shiller of Yale, who won the Nobel Prize in economics in 2013, has been surveying investors about their expectations since 1989. Dr. Shiller and two colleagues (Goetzmann and Kim) recently released a draft of their analysis of “Crash Beliefs From Investor Surveys”.
The study supports the idea that investor beliefs are heavily influenced by what recently happened, and the effect of bad news is reinforced by how it is reported in the media. As Zweig says, “the investors’ forecasts regularly look more like aftercasts – simple projections of the recent past into the future.”
Zweig goes on to note that institutional investors are little better than individual investors at predicting the future of markets. In the two years leading up to the financial crisis in 2008, the majority of financial professionals thought the chances of an imminent crash were nil, and then they turned maximally pessimistic in February 2009, when the market was near bottom and about to make a significant recovery.
This study seems particularly relevant in the context of what has happened so far in 2016. As market values dropped as much as 10% early in the year, pessimism continued to build. Optimism returned as markets recovered, and we ended the first quarter in the black. We all feel better, even though the real world hasn’t really changed much.
The recent analysis by Dr. Shiller and his colleagues seems to suggest once again that investors are not very good at predicting the market, and their emotions tend to reflect what just happened, which is not helpful in predicting the next turn. This phenomenon may be explained by the ways our brains are hardwired to work, but allowing behavioral biases to affect investment decisions can be detrimental for professionals as well as non-professionals.
Conclusion: Do not trust your gut when it comes to investment decisions. Take the emotion out, and avoid decisions based on a prediction of the future. Instead, develop a strategy that reflects an appropriate level of risk, and stick with it. Our job as an investment advisor is to help develop that strategy and to reinforce our mutual commitment, especially when recent events and emotion try to weaken our resolve.