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Keeping Our Heads

Jonathan Clements

WHAT WORRIES ME? It isn’t the stock market, but rather stock market investors.

Despite all the hand-wringing, this doesn’t strike me as an especially dangerous time to own stocks. Corporate earnings are rapidly recovering from last year’s economic shutdown—not exactly a scenario where you’d expect a big stock market decline. Meanwhile, bonds and cash investments are offering scant competition for investors’ dollars, which is another reason to be bullish on stocks.

But even if the overall market appears no riskier than usual, there’s a danger that we’ll put ourselves in financial peril—by falling into one of these three behavioral finance traps.

1. Overconfidence. As financial markets rise, so too does our confidence. There’s nothing like making great gobs of money to make folks think they’re smarter than they really are. What if their results are mediocre compared to the market averages? Investors are often blissfully unaware—and simply assume they’re beating the market.

One indicator of our collective overconfidence: Average daily stock market trading volume in 2020 and 2021 has been running 63% above 2019’s level. When investors trade, it’s typically a sign they feel they know what they’re doing. But all that trading is costly. Sure, we might not pay a commission when we buy and sell stocks. But we still lose money to the bid-ask spread, the slight difference between the price at which we can currently purchase a stock and the lower price at which we can sell.

Even more worrisome, overconfidence can lead us to make big, undiversified investment bets. For some, those big bets will pay off handsomely—but, for most, the result will be market-lagging returns. How can I be so sure? Almost every year, the stock market averages are skewed higher by a minority of stocks that post spectacular gains, leaving most stocks with market-lagging performance. If we aren’t lucky enough to own the big winners, we’re destined for subpar returns. This is a reason to own total market index funds, which ensure we own all stocks, including each year’s superstars.

2. House money effect. Overconfidence can lead us to make risky investment bets. Adding fuel to this fire: the house money effect. What’s that? Think of casino gamblers who get lucky early in the evening. They now feel like they’re ahead of the game and playing with the house’s money—and that can prompt them to make even bigger bets.

The same thing happens with investors. After the spectacular U.S. stock returns of the past decade, many investors are financially far ahead of where they expected to be. The danger: They figure they can afford to take yet more risk by, say, dabbling in individual stocks or taking a flier on cryptocurrencies—and those bets could come back to haunt them.

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Over the past year, we’ve seen a variation on the house money effect, and I suspect it’s especially prevalent among newbie investors. Their surprise windfall came not from the market, but in the form of stimulus checks and lower spending during the pandemic. They’ve taken this “found” money and started dabbling in meme stocks, dogecoin, Tesla and goodness knows what else.

Two decades ago, I fell prey to a similar phenomenon. In the late 1990s, I received $8,000 when my father cashed in a life insurance policy on which I was a co-beneficiary. Emboldened by both this windfall and that era’s euphoria, I strayed from my usual indexing strategy and used that $8,000 to buy four individual stocks. One company got taken over at a handsome premium. Two performed okay. And one plunged almost overnight—and I bailed out when the stock was down some 80% from my purchase price and on its way to zero. I haven’t owned an individual stock since, except a few hundred shares of my last two employers.

3. Extrapolating returns. Last year, many investors crowded into some of the market’s highest fliers, including Peloton Interactive, Netflix and Tesla, only to see these stocks struggle in 2021. In many cases, it seems folks were buying these stocks simply because they’d gone up and they naively assumed those gains would continue.

But these days, investors don’t just chase performance. They also flock to the internet to loudly proclaim their devotion and get encouragement from others, all this leading to dangerous herding behavior. For instance, earlier this year, the higher cryptocurrencies climbed, the more virulent supporters became—only to fall almost silent during the recent rout. This phenomenon even infects staid value investors. These folks have been notably quiet in recent years. But with value outperforming growth in 2021, those whose portfolios have a value tilt are more likely to mention it in public.

Some degree of investment conviction is a good thing. It helps us to stick with our portfolio when markets turn rough. But we shouldn’t let conviction morph into blind loyalty. Today, folks will defend their favorite investments with a fervor usually reserved for a local sports team or a preferred political party. But no undiversified investment deserves that sort of undying love.

As I mentioned in an article earlier this year, thanks to the market’s efficiency, there’s no reason to think professional investors will be any more successful than amateurs at picking winners. Instead, I believe the hallmark of professional investors—as well as prudent amateurs—is that they think more about risk.

We’ve seen the S&P 500 climb 16% this year, ignoring dividends. But we’ve also seen some much-ballyhooed investments badly stumble, with Tesla down 27% from its high, bitcoin off 48% and ARK Innovation ETF down 21%. The lesson: The market giveth—but, if we behave foolishly, it’s all too easy to see those gains taken away.

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HERE ARE THE SIX other articles published by HumbleDollar this week:

  • “A coach I worked with asked me how things were going,” recalls Don Southworth. “My team wasn’t doing too hot and I wasn’t doing too hot, either. After a few minutes, she said, ‘Ah, you’re being your results’.”
  • Want to reduce the risk that a cyber-thief empties your financial accounts? David Powell offers a five-step protection plan.
  • “For retirees, what matters isn’t the size of their nest egg, but the lifestyle it can support—and I fear $1 million won’t support the lifestyle it once did,” writes Aaron Brask.
  • When the McClatchy Company filed for bankruptcy last year, that put at risk Greg Spears’s small pension from his time as a newspaper reporter. Here’s what happened next.
  • Dennis Friedman likes to hide cash around the house—but he doesn’t like it sitting in his portfolio. Sound odd? Dennis explains his thinking.
  • “One of the reasons our economy has been a success is our acceptance of failure,” says Joe Kesler. “If bankrupt entrepreneurs are excessively punished, they may give up on high-return opportunities.”

Jonathan Clements is the founder and editor of HumbleDollar. Follow him on Twitter @ClementsMoney and on Facebook, and check out his earlier articles.

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Roboticus Aquarius
Roboticus Aquarius
7 days ago

It was very helpful when I first read that anyone investing in stocks needs to be able to accept a 50% haircut at any time. This is a very concrete personalization of ‘risk’, and when i think I’m forgetting my true risk tolerance, I reconsider what a 50% decline would mean for me.

Richard Gore
Richard Gore
13 days ago

I agree that investor behavior is worrisome!

The question that I have is what besides avoiding excessive speculation should we do. For instance, does item #2 also suggest that we should rebalance our stock allocation if it has grown past our target.

What are you doing with your portfolio? Are you taking money out of the stock market?

Jonathan Clements
Admin
Jonathan Clements
12 days ago
Reply to  Richard Gore

Since buying stocks heavily in February and March 2020, I’ve done very little. Here’s what I wrote in April:

https://humbledollar.com/2021/04/hanging-tough/

Since then, I did a very modest amount of rebalancing, but I’m still overweight in stocks. Will I do more rebalancing? I’m thinking about it. One thing that’s dissuading me: Fingers crossed, the sale of my old apartment will close at the end of August and that, by itself, will mean an influx of cash into my portfolio. If that wasn’t in the works, I’d likely do more rebalancing right now.

Richard Gore
Richard Gore
12 days ago

Thanks!

Gary Palmer
Gary Palmer
14 days ago

If nearly everyone is bullish, as they seem to be now, this means they are fully or close to fully invested. In which case where does the money come from to push stocks higher? It seems to be coming from rotation out of other sectors. If it comes from the overpriced high flyers, as just about everyone has been encouraging us to do, it will result in a broader and more balanced market.
Perhaps the biggest problem is that we have a new generation of young investors who have never witnessed a bear market, and when they do it will be startling and costly. That’s the only way they will ever start to appreciate risk.

Ormode
Ormode
14 days ago

Unfortunately, irrational exuberance may have seeped into the S&P 500. A mere six large tech stocks account for 30% of the index, and nearly all of the growth in the past 5 years. Is this the wisdom of the market, or the folly of crowds? Would you buy these six stocks at 50-100 times earnings?
For even the most conservative investors, the desperate search for any sort of return has pushed up a lot of unlikely stocks. Most utilities are now trading at more than 20 times earnings, paying less than 4% with an 80% payout ratio. These are the kinds of securities retirees used to be able to rely on, but now may be a trap if interest rates suddenly rise.
Is anything safe? No, not right now.

booch221
booch221
14 days ago

Despite all the hand-wringing, this doesn’t strike me as an especially dangerous time to own stocks.

This sentence seems to imply there’s a safe time to own stocks and a dangerous time, and that investors should be out of the market during the dangerous time.

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