Fear and Greed: Repeat Until Broke

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Behavior Gap

 

 

Emotion + Investment = A Recipe For Disaster

The constant stream of information, daily stock prices, and the inevitable crises that inundate the news, all serve as a non-stop invitation for our emotional forces to enter into our financial and investment related decisions.  The result can be seen in the above illustration by Carl Richards.

When the universal human emotions of fear and greed (excitement is another word) influence our investment decision making, it becomes all too easy for us to ignore the evidence that tells us that markets are volatile, and that attempting to time the market or identify mis-priced investments will likely lead to poor long-term results.

Your Goals + Your Actions = A Recipe for a Plan

Instead of allowing our behavior to sabotage our long term goals, focus on the the things that you can control over time. Save, invest, re-balance, delegate responsibility, manage costs, set goals, and enjoy life!

 

Image Attribution: Carl Richards, (c) Behavior Gap 2013

Ignoring the Siren Song of Daily Market Prices

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Do you try to go to the gas station as soon as the price of oil futures change?  Probably not.

(And if you did, the price will probably have already changed by the time you get there.)

 

News, Inglorious News

What causes market prices to change? It begins with the never-ending stream of news informing us of the good, bad and ugly events that are forever taking place. For example, when there are reports that a fungicide is attacking Florida trees, orange juice futures may soar, as the market predicts that there’s going to be less supply than demand.

 

But what does this mean to you and your investment portfolio? Should you buy, sell or hold tight? Before the news tempts you to jump into or flee from breaking trends, it’s critical to be aware of the evidence that tells us the most important thing of all: You cannot expect to consistently improve your outcomes by reacting to breaking news.

 

Great Expectations

How the market adjusts its pricing is why there’s not much you can do in reaction to breaking news. There are two principles to bear in mind here.

 

First, it’s not the news itself; it’s whether we saw it coming. When a security’s price changes, it’s not whether something good or bad has happened. It’s whether the next piece of good or bad news is better or worse than expected. If it’s reported that the aforementioned orange tree disease is continuing to spread, pricing changes may be minimal; everyone was already expecting doom and gloom. On the other hand, if an ingenious new fungicidal treatment is released, prices may change dramatically in reaction to the unexpected resolution.

 

Thus, it’s not just news, but unexpected news that alters future pricing. By definition, the unexpected is impossible to predict, as is how dramatically (or not) the market will respond to it. Once again, group intelligence gets in the way of those who might still believe that they can outwit others by consistently forecasting future prices.

 

The Barn Door Principle

The second reason to consider breaking news irrelevant to your investing is what we’ll call “The Barn Door Principle.” By the time you hear the news, the market already has incorporated it into existing prices, well ahead of your ability to do anything about it. The proverbial horses have already galloped past your open trading door.

 

This is especially so in today’s micro-second electronic trading world. In his article, “The impact of news events on market prices,” CBS MoneyWatch columnist Larry Swedroe explored how fast global markets respond to breaking news. Pointing to evidence from a number of studies among several developed markets, the universal response was nearly instantaneous price-setting during the first handful of post-announcement trades. In the U.S. markets, it was even faster than that.

News travels quickly, and prices can adjust in an instant. For Example, in the image below, the change in Berkshire Hathaway’s shareprice can be seen immediately after the purchase of Heinz is announced.

 

 

 

In other words, unless you happen be among the very first to respond to breaking news (competing, mind you, against automated traders who often respond in fractions of milliseconds), you’re setting yourself up to buy higher or sell lower than those who already have set new prices based on the news – exactly the opposite of your goal.

 

Your Take-Home

Rather than try to play an expensive game based on ever-changing information and cut-throat competition over which you have no control, a preferred way to position your life savings is according to a number of market factors that you can better expect to manage in your favor. In future Evidence-Based Investment Insights, we’ll introduce these factors to you.

 

But first, you may be wondering: Even if you aren’t personally up to the challenge of competing against the market, you may think you can select a pinch-hitting expert to compete for you. Next up, we’ll explore the strikes against that tactic as well.

 

Evidence-Based Investment Series #3: Financial Gurus and Other Unicorns

 

Woodstone Financial, LLC is a fee-only financial planning and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services.