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Investors Not Always Rational

By: William Jack

In classical economic theory, investors always behave in their own rational self-interest.

Recent research in the field of behavioural finance shows that this is often not the case. Chart 1 includes the change in the U.S. S&P 500 Index during the dot.com bubble and the net inflows/outflows from U.S. domestic equity funds for the same time period (reflecting fund purchases/sales).

Chart 1: Change in the U.S. S&P 500 Index During the dot.com Bubble
Graph Showing Change in the U.S. S&P 500 Index  During the dot.com Bubble

The chart shows that when the value of the S&P Index reached a maximum in the fourth quarter of 1999, investors rushed to purchase domestic equity funds. When the S&P Index reached a minimum in 2001, investors rushed to sell them. Instead of pursuing their rational self-interest, investors actually 'bought high, sold low.'

While the chart is based on U.S. experience with the dot.com bubble, it certainly reflects my experiences with friends and clients in the 2008 market downturn. As one client said to me, "Markets may be bottoming soon; I am bottoming out right now. I called my advisor to sell everything."

The recent book, 'The Behaviour Gap' by Carl Richards, describes his experiences as a financial advisor in both the dot.com bubble and the debt crisis of 2008. In particular, he describes how people were pulling the equity out of their houses in 2007 to buy more stocks … just before the crash.

Chart 2: Greed-Fear Diagram
Greed-Fear diagram

He explains that the pain of losing a given amount of money is greater than the pleasure felt when you gain the same amount. The 'pain of loss' creates fear that motivates people to sell low. When stocks are climbing, the fear of losing out triggers greed that motivates people to buy high. His book contains Chart 2  illustrating this behaviour and its inevitable ending.

Warren Buffet summarizes of one of his key investment strategies: "I get fearful when people start getting greedy and I get greedy when people start getting fearful."

William Jack is with William D. Jack & Associates (http://www.williamjack.ca/).

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