Having been invested in the market for the past 5 years, it seems too easy, at times falling a little complacent to extrapolate past performances to future returns. 5 years of experience in the market is not extremely long nor can it be considered short. The truth is there’s plenty to learn from our own mistakes from the time we started investing to where we are at currently.
There are some people who have been in the market for decades and more often than not, they are likely to be equally complacent and greedy and are likely to repeat their mistakes. We often hear how deep recessions in the economy put strains on the job market and provide a stern test to the investors’ mettle. The weak investors are usually wiped out during these periods and they are the ones usually afraid to be further engaged in the stock market. New investors will come into the market and the cycle repeats until a bubble is formed and we are back to where we are.
William Bernstein has categorized these different groups of people discretionarily in his book Rational Expectations. He chose to focus on the important behavioral issues that are often the stumbling block for most investors.
Group 1: The average retail investor, who does not have a coherent asset allocation strategy and who owns a chaotic mix of mutual funds and/or individual securities, often recommended to him or her by a broker or advisor. He or she tends to buy near the bull market peaks and sell near bear market troughs.
Group 2: The more sophisticated investor, who does have a reasonable-seeming asset allocation strategy and who will buy when prices fall a bit (“buying the dips”), but who falls victim to the aircraft simulator/actual crash paradigm, loses his or her nerve, and bails when real trouble roils the markets. You may not think you belong in this group, but unless you’ve tested yourself and passed during the 2008-2009 bear market, you can’t really tell whether you are an experienced or virgin investor.
Group 3: Those who do have a coherent strategy and can stick to it. Three things separate this group from Group 2. First, a realistic appraisal of their true, under fire risk tolerance. Second, an allocation to risky assets low enough, or a savings rate high enough to allow them to financially and emotionally weather a severe downturn. Third, an appreciation of market history, particularly the carnage inflicted by the 1929 – 1932 bear market. In other words, this elite group possesses not only patience, cash and courage, but also the historical knowledge informing them that at several points in their investing career, all three will prove necessary. Finally, they have the foresight to plan for those eventualities.
Group 1 is often the group of people we’ve seen appearing and very actively involved in the bull market. They do not usually employ an asset allocation or risk management strategy and have the tendency to panic for every single market movement across the index. When financial markets start to turn bearish, these are the same group of people who will lead the losses as they will panickedly sell off their holdings without much strategy in place. They tend to look for short term profits in nature and see the stock market as a function of casino alike. They are also emotionally and psychologically the weakest in times of both the bull and bear market. A good example of this is the herd mentality concept I’ve often talked about recently.
Group 2 is probably the hardest to disseminate and where everyone thinks they belong to in the category. These group of people are usually slightly more sophisticated than the previous group and think deeper before they made the decision to invest in the market. These group of people are also aware of the importance of a proper asset allocation but given their vastly lack of experience in the market cycle, they have not been seriously tested in terms of emotional and psychological investing. In his book, Bernstein mentioned: “If you began your investing journey after 2008, or haven’t started yet, then you’re an investment virgin.”
Group 3 is defined as the ultimate of all the category. Having tons of experience in the market does not automatically qualify the investor to be in this category, but these group of people have usually plenty of experience dealing with the ups and downs of the full cycle of the market. The investor in this category is able to dissect the emotional factor from the investing and the willingness to take risks is paramount much more than the movements of the daily market volatility. There’s a lot of psychological awareness that the previous 2 groups lack in terms of past historical incidents in the market and the three combinations of patience, courage and foresight are what that makes them stand out from the rest.
Now that you know, which category groups do you think you belong to?