Posted by on Feb 14, 2012 in Articles & Advice, Blog, Columns, Featured |

Image Credit: Christophe Vorlet

By Jason Zweig | Feb. 11, 2012

Past returns are no guarantee of future success. Just like smokers ignoring the Surgeon General’s warning on the side of cigarette packs, investors overlook the most obvious caution about the stock market at their peril.

Even after Friday’s stumble over renewed fears about Europe, the Standard & Poor’s 500-stock index has gained 7% so far this year, and the Russell 2000 small-stock index is up 11%.

Why is it so hard for investors to regard such short-term hot streaks with the cold eye they deserve?

Decision Research, a nonprofit think tank in Eugene, Ore., has conducted a nationwide online survey of investors seven times since 2008. These surveys have shown that investors’ forecasts of future returns go up after the market has risen and down after it has fallen.

William Burns, an analyst at Decision Research, says investors’ forecasts of the market’s return over the coming year were heavily swayed by how stocks performed in the previous month.

They might not have had a choice. The investing mind comes with built-in machinery that sizes up the future based on a surprisingly short sample of the past. Neuroscientists say the human brain probably evolved this response in a simple environment in which the cues to basic payoffs like food and shelter changed slowly and rarely, making the latest signals most valuable—nothing like what today’s investors face with electronic markets in a constant state of flux.

Experiments led by neuroscientist Paul Glimcher of New York University found that cells deep in the brain calculate a sort of moving average of past events, giving the greatest weight to the most recent outcomes.

When the latest rewards turn out to be better than the long-term pattern, these neurons fire unusually quickly, spreading a burst of dopamine—the neurotransmitter that triggers the pursuit of reward—throughout the brain.

Thus, after a decade of mostly dismal stock returns, even a month or two of outperformance might prompt you into an impulsive plunge back toward stocks.

Some investors seem to have learned how to resist this tendency, and you should, too.

Charles Manski, an economist at Northwestern University, has analyzed how people form expectations of what the stock market will do next. Based on nationwide surveys of households conducted from 1999 through 2004, he has identified three main types of amateur forecasters.

Just over 40%—the largest group—believe recent performance is likely to persist. Another third of investors think recent returns are likely to reverse. Finally, roughly one-quarter of people think returns are random and essentially unpredictable.

But each of these attitudes carries a distinctive kind of risk.

Investors who believe returns are unpredictable should, in the long run, capture the general rise in stock values that patient investors have generally received in the past. But, in the short run, they won’t sidestep a big drop in the market.

Investors who believe recent returns are ripe for a reversal can sell too soon in a bull market and buy before a bear market hits bottom.

Those who think recent returns will persist are especially prone to error. If you think a hot market is likely to get hotter, you will have no qualms about buying high; if you believe a bad market is bound to get even worse, you will end up selling low.

Here are a couple of steps you can take to minimize your odds of ramping up your exposure to stocks as their prices rise.

First, think back to the last time you felt certain you knew where the market was headed. Were you sure, at the beginning of 2011, that interest rates had to start rising soon? Were you convinced, in March 2009, that stocks were bound to keep dropping? The mere act of pausing to ask yourself how reliable your intuitions are might be enough to make you recognize that you need better justifications before you take action.

Then force yourself to come up with several solid reasons why the U.S. stock market is undervalued enough to justify suddenly increasing your exposure to it. And no cheating: You can’t use “because it’s been going up lately” as one of your reasons. While you are at it, think of a few factors that might make stocks stop going up.

Write down your reasons, so you can look back later and review your logic. The best way to learn from your forecasts—right or wrong—is to track them over time.

None of this means you shouldn’t own stocks. It simply means you shouldn’t rush into buying more just because the market has had a flashy rise.

Decisions made in haste usually turn out to be mistakes—and big decisions made in haste almost always turn out to be big mistakes.

Source: The Wall Street Journal