Behavioral Finance

Checking the Inner Gut Strategist

Economic growth and positive market returns continued in Q1 2011. But what of investor sentiment?

Story Highlights:

  • Positive economic data and market results continued to arrive Friday.
  • More investors today appreciate the positives, but behaviorally, some lessons seem unlearned.
  • Rationalizing errors away is a missed opportunity to improve investing discipline.

Data released Friday showed the economic growth few believed possible two years ago continues apace. Consider just the short list below:

  • March purchasing managers indexes from the US, eurozone,UK, China, Taiwan, and South Koreawere all expansionary.
  • Brazilian industrial production surged 1.9%in February—easily eclipsing estimates.
  • Employment data in the US improved, with US private employers adding over 200,000 jobs and the headline unemployment rate falling to 8.8%.
  • Eurozone unemployment(which dipped by 77,000) continued to illustrate a divergence between core and peripheral European economies (like Ireland and Portugal), while France’s unemployment rate fell and Germany’s declined to 6.3%.
  • And for stocks, Q1 finished with solidly positive returnsdespite much handwringing over MENA concerns, Japan, and other events.

While some folks still remain persistently bearish, it’s no surprise seeing data like the above (and there are far more) have converted some investors from naysayers to bullish believers. And all these facts—among others—argue against a new bear market in 2011. Recently, many major publications have run stories directly or indirectly highlighting improved investor sentiment (examples hereand here). These pieces highlight two important points: First, some investors now see and better appreciate currently strong fundamentals (as we’ve discussed). And second, many investors are still rationalizing away incorrect gut decisions made near the bear market’s trough two years ago.

The second point isn’t a huge surprise. But folks who changed their strategy based on losses already suffered during the bear market were in many (if not most) cases not being prudent; they were making an emotional, or gut, decision. And one that could very easily have resulted in missing either a portion—or worse, all—of the approximately 100% global stock market returns from March 9, 2009 to the present. It may have felt good in those troubling times to alleviate exposure to market volatility and reduce the associated short-term stress. But if applied at the wrong time, these decisions can easily backfire in very tangible, dollar-driven ways—reducing the probability of reaching financial goals.

Further, trying to recoup the missed opportunity of stellar returns over the past two years is going to be exponentially difficult to accomplish. And some investors might be applying heat-chasing greed in an attempt to recoup fear-driven lost opportunity by hugely concentrating in areas with hot recent returns—the wrong prescription for a misdiagnosed problem.

While there’s no sense in becoming a modern-day flagellant, emotion-based errors can provide a learning opportunity to improve investing discipline—if you dispense with the rationalization of emotional decisions. (Even if you didn’t make these errors, you can learn from others.) Embrace this point: Stocks do not care about some vague philosophical disagreementone might have with their perception of economic conditions, nor do they care about investors’ sleeping habits.

Investors who truly care about results will not shun mistakes. They’ll shun emotional biases, knowing their guts might appreciate bacon but can’t discern between action based on insight into the thousands of data points and other factors that cumulatively drive markets and an emotional interpretation of them.

While extant fundamentals (like our bullet-pointed list above) speak to a continuation of the bull market ahead, the gut strategists who figure the last two years’ outsized positive returns simply carry forward in 2011 are overlooking their own existence. And those still bearish are ignoring a multitude of data that doesn’t support the view. What both today’s very bullish and very bearish have in common is a tendency to base an outlook on emotions influenced by past events—it’s just a matter of how far back they reach. An emotional interpretation of the past is not a good way to assess inherently forward-looking markets.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.