What have we really learned from the 2008 financial crisis?By Jim Pratt-Heaney
“A Wesleyan University study showed that financial analysts were correct a third of the time, and weather forecasters two-thirds of the time.”
We all remember the headlines: “The worst financial crisis since the Great Depression”; “The markets have changed forever”; “Investors head for safety.”
The year 2009 began with world markets down 40 percent, the banking system under stress and predictions of doom everywhere. Would we recover from this crisis? Many investors reacted to what they “knew” was going to happen: The decline, they said, would worsen. But then 2009 saw a massive rally in financial assets, even as many investors remained frozen in fear, bidding Treasuries to negative yields and showing themselves willing to suffer certain, quantified loss rather than risk the unknown.
The next year, 2010, brought more negativity as headlines amplified predictions of potential massive defaults roiling municipal bonds with a large sell-off, only to set the stage for a subsequent rally once cooler heads prevailed.
A Wesleyan University study recently revealed that people are generally overconfident when they make predictions; in fact, the more confident they become, the less accurate they are. The Academy of Entrepreneurship and Management in Warsaw asked two groups of experts to “predict corresponding events: the value of the Stock Exchange Index and the average temperature of the next month.”
The results: The study’s financial analysts were correct a third of the time, and weather forecasters two-thirds of the time. Those with a confidence rating of over 80 percent were correct only 45 percent of the time.
The point is not to denigrate analysts but to show the weight investors give to their predictions. The human tendency is to focus on recent events and behave in reaction to them. Analysts, being human, rarely look beyond the short term. For example, in 2000, nearly all new funds added to stock mutual funds went into technology because events suggested there were no limits on how high technology stocks could soar. This approach turned out badly.
Such questionable information clouds the mind of investors. Their aversion to loss can distort allocations, leading to overweighting asset classes that address only current concerns. Frequent and complex performance reporting tends to decrease equity allocations because it focuses on short-term results. “Anchoring” causes investors to seek information that supports only their point of view, reinforcing fears and causing aversion to what is seen as obvious risk.
This global crisis has shown us that emphasizing recent negative events too much makes investors so short-sighted that even the rumor of an event can send markets into a dive, followed by recovery when the facts unfold. This near-term focus, given the world events we see every day, has made investors so negative that they cannot imagine any positive scenario. This, plus overconfidence in personal or “expert” opinions, has caused some investors to abandon their financial plans and miss major market moves. Their fear of regret makes them sell when the market has already gone down, and refuse to get back in because it has moved to new highs.
What we have learned in the last three years is no different from what we always knew: The emotional investor is the unsuccessful investor. When market trends look obvious, they rarely are. Predictions by experts are often flawed. Investors flock like sheep to the newest idea or product (witness the unbelievable growth of ETFs, though few investors know their structure or counter-part risk). In conclusion, we believe that the best way to successfully invest for your family’s future is to take the emotion out of the process by creating an in-depth financial plan, sticking with it and rebalancing when necessary. Leave the predictions to others!