Lowing and Highing

As we saw in The Proper Etiquette for Market Panics – which I wrote the last time we had some major market falls – what usually happens in a crisis is that markets fall and then exhibit volatility, as investors roam backwards and forwards in increasingly large herds while asking everyone else why it's happened and what they should do about it. Often the noise they make sounds suspiciously like cattle lowing.

Well, this happens (the volatility, not the lowing) because going down – and up – is what markets do, and if you don't understand that you shouldn't be allowed to play Monopoly, let alone invest in stocks. And asking what you should do about this after the event betrays a depressing level of incompetence and a woeful grasp of history. On the other hand a bit of cognitive dissonance can be just the trigger to for a teachable moment; the point at which a handful of people actually learn to be proper investors.

Dissonant Behavior

Cognitive dissonance is the feeling of discomfort we experience when we act in a way that conflicts with our beliefs about ourselves. Most typical, well adjusted people have a healthy and positive self-image and they don't like to disturb it by doing anything so self-aware as acknowledging any of their numerous vices. So we manipulate our beliefs to bolster our self-image and reduce our feelings of cognitive dissonance.

This can be particularly tricky for investors, especially less experienced ones, who are apt to convince themselves that they're financial geniuses simply because their stock portfolio has gone up in value. When the inevitable reversal comes there are one of two possible reactions to the cognitive dissonance this entails. Firstly the investor could acknowledge that actually they don't have much of a clue and that their prior successes were down to luck; or they could continue to believe that they're an investing genius and attribute their misfortune to the evil machinations of governments or aliens, or evil financiers, or something.

Now what do you think most people do?

Chasing Hubcaps

The evidence suggests that investors chase returns the way dogs chase hubcaps, with much the same results. money flows into popular fund sectors months after they've become successful and then flows out months after they've started to fail in order to chase the next big thing. It happens with index funds as well (see: The Wrong Way to Use an Index Tracker). People just don't seem to learn that this is a surefire way of underperforming the market – even in bull markets most active investors fail by some distance to capture the market return, because they're too busy trading and congratulating themselves to actually notice some boring index tracker is roasting their returns.