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The Fear and Greed Behavior Gap

Wed, 11 Jan 2012

Investors' genetics hard-wire them to make inopportune purchases and sales, says financial planner, New York Times blogger, and author Carl Richards.

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Video Transcript

Christine Benz: Hi I'm Christine Benz for Morningstar.com.

Investors often behave in ways that run counter to their own interests. Carl Richards, a financial planner, a blogger for The New York Times, and a contributor to MorningstarAdvisor.com has written a new book that addresses this tendency and it's called The Behavior Gap. He is joining me via Skype to talk about it today. Carl, thank you for joining me.

Carl Richards: My pleasure. Thanks for having me.

Benz: So your book, Carl, The Behavior Gap features a number of sketches, most of which originally appeared in The New York Times and you use them as kind of a framework for teaching some of these broader concepts about investment mistakes that people often run into.

Let's start with the one that is on the front cover of the book. This is the one that looks at the difference between fear and greed and how investors often shoot themselves in the foot by making inopportunely timed purchases and sales.

Richards: This is one of those things that we often, when it comes to money, we make it way more complicated than it needs to be. Investing success is pretty simple. We all learned, probably when we were pretty young, you buy some investment low, and you will hope to sell it at a higher price later.

But what we often see, because of this hard-wired issue we have with fear and with greed, is we see people get very, very excited, and that turns into sort of greed after an investment has done really well, and one of the best examples of that is late '99, and still easy to pick on, the tech bubble.

As an example, right after we had this huge run in '97, '98, '99, you saw massive inflows into equity funds, and specifically large-cap growth and technology funds, in January, February, and March of 2000. In fact, we shattered all previous records. But what's so fascinating about it is that it was right after a huge run, not before, but right after.

So ... this is kind of a genetic, almost a genetic, issue. We want more of those things that are giving us pleasure or satisfaction or security, and we want less of those things that are giving us pain.

So we tend to pile in at the top, and we're notorious for it, and then we bail out at the bottom, and it's the only thing that we purchase that way. We want to buy more when it's marked up, and we want to get rid of it when it's on sale. So that's what that sketch was about.

Benz: So one thing you mention in the book is knowing yourself and knowing your own tendencies toward fear and greed can help you manage around those issues. Let's talk about what you mean by that?

Richards: I think that one of the great things about investing is that we have records. We have proof of our own behavior. Now, it's often very painful to face, but this is a suggestion--this is a great thing to do, especially given this new year, new start. Go back and look; you've got your brokerage statements. You've got your tax returns from the last 10 years if you've been investing that long. You've got your 401(k) statements; go look.

Did you find yourself wanting to buy Infospace or Pets.com in '99, like I did? Did you find yourself selling and going to fixed income and to bonds in 2002? Did you find yourself wanting to become a real estate investor in 2006 and '07, only to bail out of everything in '08.

And I think if you go back and look, you can get a feel for, that was how I really behaved. And if you find, and a lot of people are this way, if you find that fear was what caused you to make the most mistakes ... I think we get in trouble when we're trying to have both. We want full participation in up markets, and we want protection in down markets, like somebody is going to ring the bell for us when things are about to turn. I think if you start to understand [that] fear plays a huge role in my life--and I'm speaking personally--I don't like, and most of us are this way, we don't like [losses]. The pain of loss as much greater than the reward of gain. I don't like losing money at all.

And so now that in 12 years, I've gotten three major lessons of that, it's finally gotten through my head that I should position my portfolio permanently to protect me against loss, and that needs to be a permanent decision.

Now with the trick, Christine, is to remember that the next time things are going crazy for a number of years, and everything is good, and ... Brian Williams is on TV telling us it's time to buy again, I can't get caught up in that, because I made a permanent decision to position my portfolio to protect me from loss and pain, because I don't want to live through that.

Benz: So you're not saying you're all cash with your portfolio, just saying that your portfolio skews toward providing some downside protection?

Richards: That's exactly right. ... Maybe somebody my age with my same set of goals would be [40% or 50%] fixed income, I may be more like [60% or 70%] because I've recognized that bias in myself. And again we'll see when we have another raging bull market if I can stick to it, but that's what my investment policy statement is there for--to help me to stick to it. But I need to realize that you can't have it both ways. So protecting myself, making a permanent decision to position my portfolio towards protecting myself, is something that made sense to me.

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