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MAKING CENTS OUT OF THE NEWS
Blog #5
(January 29th, 2009)
BLOWING BUBBLES WITH THE HERD
By Tom McAllister, CFP™
Smart people still "herd", I've concluded, and herding behavior still leads in only one direction - investment bubbles. Now that 2008 is history, along with 40% losses in virtually every stock index, I have fallen to musing. How did this happen? What can save smart people (my clients, my readers, and me) from bubbles down the road?
I must give myself credit for the fact that, back during the l990's tech bubble, I advised avoiding technology stocks. After that tech bubble burst in 2001, the public began herding towards real estate as the "next new, big thing." I advised staying light on housing stocks, in fact on anything to do with the real estate boom. Still, the lethal combination of relaxed regulation of lending, mortgage securitization, and the proliferation of trading in derivative mortgage securities (with little local oversight of the actual market value of the underlying properties), all examples of "herd" behavior, led inevitably to the failure of our credit system. Once again, with common sense trampled underfoot, a bubble burst.
Two interesting sidebars to the bubble phenomenon may be seen in the relationship between investment management professionals and investors. Money managers are paid a fee (typically measured quarterly or semi annually as a percentage of the value of an account or group of accounts). The perception is that a money manager is not being paid to sit in cash, at least not a lot of cash, for very long. Clients have limited patience if there is a bubble going on and they feel "left out" of the action. Among money managers, benchmarking, which is comparing one's methods, strategies, and results with those of one's colleagues, is a positive way to learn from one another, without herding.
Over the four and a half decades I've been in practice, my observation is that a good part of the job we investment advisors perform consists of dealing with client expectations. When a bubble is building, the herd mentality says, "Hurry up and buy into this wonderful thing everyone's talking about! I don't want to be too late to the party!" Of course, the most prudent advice during a bubble is to take some profits in over-valued stocks, build a cash reserve of 10-30%, and buy defensive stocks, including utilities, food, and personal consumption stocks. An advisor's challenge is communicating this wisdom to his clients.
The inability to separate short-term investment results from long-term personal investment goals is what leads, I believe, to herding behavior. Intelligent, well-educated people are in a way even more susceptible to this trap than their less sophisticated peers. The financial media, in a quest to sell advertising, promote the do-it-yourself electronic trading system of investing. This approach has particular appeal for smart investors who, in reality, lack certain vitally important "smarts". Despite their education and willingness to devote time to their own finances, this audience is quite often induced by the lure of bargain-rate transaction fees to steer away from the very professional money management they need to achieve their goals through true diversification and asset allocation.
Where does financial planning fit in? It is, I believe, precisely the individual goal-setting piece, at the heart of the financial planning process, that has the power to save us from our tendency to follow the herd. In hundreds of personal meetings with clients and passengers on my lecture cruises, I've seen this principle at work again and again. Your goals are yours alone. What others may do to achieve their goals is not relevant to you. My function in a financial planning interview is to opine on the reality and achievability of a goal, not to pass judgment on the goal itself. Ultimately, no matter what is happening in the economy, no matter from which direction winds may blow, goals, and the values upon which those goals are based, provide the reason for an investor to stay on course.
Financial planning is the one and only antidote to herd thinking and therefore to bubbles. Herd behavior increases risk (herd mentality leads us to rationalize evidence to justify chasing the bubble); financial planning manages risk. The virtue of financial planning, when all is said and done, lies in its ability to make individual investing - individual!
With all the rapid changes in our economy and in the investment markets, there are many investors who would benefit from more consistent guidance. We are currently accepting new financial planning and investment clients, and would appreciate your referrals.
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