By Juan C. Ros on April 26, 2013
Here’s a short quiz: When the stock market is going up, do you: (1) get excited and want to keep riding the upswing to maximize profits, or (2) sell stocks to take money off the table? Similarly, when the stock market is in a freefall, do you (1) get scared and sell your stocks to stop the bleeding, or (2) buy more stocks even while your friends are heading for the exits?
Many investors pick answer No. 1 to both questions when they ought to be picking answer No. 2. Here’s why the second option is the smarter one.
One of the most common behaviors in investors is the herd instinct. This is characterized by investors who make investment decisions based on the decisions of their peers, colleagues, or friends, regardless of the facts. The dot-com boom and bust of the late ‘90s and early 2000s, and most recently the housing bubble that led to the financial crisis in 2008, are recent examples of the herd mentality.
When the market tanks as it did in 2008, many investors panic and try to get out of the stock market as soon as possible. In 2008, many investors did pull out of stocks — a move that turned out to be to their detriment when the market turned around in March 2009.
Similarly, when the market is riding high, as it did before the tech bubble burst in 2000, investors want to keep buying. The fear of losing out when everyone else is “in” is a major factor that contributes to herd instinct behavior.
To fend off such behavior, establish rules to help you determine your next steps. This way, you’re behaving more like the shepherd than the herd, and, in turn, guiding your own investments. No matter what the herd is doing, stick to your rules.
One simple rule is to be well-diversified by owning an appropriate mix of stocks and bonds, and different types of stocks and bonds that behave differently depending on the “weather.” A certified financial professional can help you determine the best mix of stocks and bonds for your situation and risk tolerance.
Once diversified, try to prevent the herd instinct by rebalancing your investments on a regular basis. When your ratio of stocks to bonds has deviated from your target, rebalancing is the process where you sell one and buy the other to bring your investments back into “balance” – back to your target mix of stocks to bonds.
For example, let’s say your target mix is 60 percent stocks, 40 percent bonds. If the market is doing well, the stock portion of your investments will increase relative to the whole. When that happens, you can sell enough stocks and buy enough bonds to bring the ratio back to 60/40.
Similarly, when the market is caught in a downward trend, your stocks will decrease relative to your bonds. In that case, rebalancing requires you to sell enough bonds and buy enough stocks to bring the ratio back in balance.
Rebalancing forces you to sell when the market is high and buy when the market is low – actions that are counter to what the herd is doing under those market conditions.
While investors can’t control the markets, inflation or interest rates, they can control their behavior and decision-making. Proper diversification and rebalancing are smart ways to increase your chance of success by avoiding succumbing to the herd mentality.
• Juan C. Ros is a wealth manager and philanthropic specialist with Lamia Financial Group in Thousand Oaks. Contact him at (805) 494-3416 or [email protected]