December 1, 2008

You Are What You Lose

 Forbes - Michael Maiello 11.21.08, 6:00 PM ET

You think you think about your portfolio. You think that you make informed decisions about buying and selling stocks and mutual funds. You're probably wrong. The bear market has likely taken over your brain.
When your favorite stock drops, your brain floods your body with mind-altering hormones that encourage irrational decisions that you will later try to justify as entirely intentional. Plummeting markets can seize hold of your personality, internalizing behavior that can control your investing decisions for years to come.
Michael Ervolini, the head of consulting firm Cabot Research, is a kind of financial Freud. While his clients stare at Bloomberg terminals, Ervolini delves the depths of the subconscious minds of professional asset managers. He's found that the so-called "smart money" have almost no discipline about selling stocks. They make most of their decisions unconsciously and often don't know why they really bought or sold a particular stock. Most professional money managers unconsciously create patterns of behavior where wrong deed feeds upon wrong deed.
This is one of the reasons why so few active stock pickers can beat the market. According to Standard & Poor's, global and domestic stock funds fail to beat the market 70% of the time. We're just not wired for investing. We don't control it, it controls us.
You're only safe, Ervolini says, if "you have a clear philosophy and approach to your investing and have built rigor, process and discipline to implement it. Then you'll understand that at times what you do will be out of favor but you'll remain committed to something bigger than you are that you know has validity."
That describes famed value manager Jeremy Grantham (who is starting to turn bullish, by the way), Warren Buffett (who seems willing to invest so long as he doesn't have to take any losses) and Legg Mason Value Trust manager Bill Miller (who is having a heck of a bad year). The rest of us are left to biology's less-than-tender mercies.
Ervolini says market losses affect the brain in the same way excrement or a foul smell does. We recoil without thinking, as if we're confronted with a disgusting and possibly harmful physical presence. This reaction stems from our unconscious desire to immediately end the pain.
"The experience of losing $1 is three times more emotionally impacting than the experience of winning $1," Ervolini says. "We learn more intensely when we lose."
Because the pain of loss is so much greater than the joy of gains, which Ervolini says affect the same parts of the brain as sex and certain narcotics, people are more likely to hang onto losing investments as they drop and to sell winners before they should. The joy of riding an investment on the way up isn't enough to overcome the fear we have of losing money if it turns. If it goes up $3, but then drops $1 from its high before we sell it, we feel pain even though we're able to sell at a profit. That $2 net gain just isn't enough.
Leroy Gross, author of the classic stock-broker bible The Art of Selling Intangibles, tells prospective stock sellers how to use the brain's chemistry to keep their rube clients in the market: "Investors are also reluctant to accept and realize losses because the very act of doing so proves that their first judgment was wrong. Investors who accept losses can no longer prattle to their loved ones, 'Honey, it's only a paper loss. Just wait. It will come back.'" This is the classic behavior of the problem gambler who wants another spin at the roulette table because the only sure path to not recouping losses is to leave the table.
But certain investors, Ervolini believes, are more vulnerable than others.
Investors who got lucky over the last couple of years, for example, are particularly at risk. "In a strong wind, even turkeys can fly," says Ervolini. "And you wind up thinking you know what you're doing."
For such folks, stock losses can completely obliterate the ego. The investors who felt clever and well informed when they beat the S&P 500 by picking homebuilder exchange-traded funds in 2005 have, subsequently, turned a loathing best directed at CNBC inward.
Workers who opened 401(k) accounts in the last decade and "have done pretty well until about six months ago" could also get caught in a psychofinancial bind.
Ervolini believes that young workers who aren't automatically opted into 401(k) plans might well avoid investing in them to their long-term detriment. Companies should opt their workers into the plans right when they hire them and put them into diversified stock and bond portfolios. After this bear market, says Ervolini, it's going to be tough for companies to sign up new 401(k) investors if they give their employees too much of a choice.

Complete Coverage--Special Report: Identity