Paying the price for greed

Greed, in the context of the world economy, was a prominent topic of discussion leading up to 2008. Today though, after the crash, greed has been replaced by fear.

From bad debt and lower consumer spending to falling home prices and high unemployment in the U.S., Europe and Japan, we’re paying the price for our greed. Sub-prime mortgages and negative amortizing debts burst the bubble in 2008, causing the worst market crash since the Great Depression.

The result: a number of Wall Street pillars vanished, many banks failed and the U.S. government agreed to the biggest public bailout of a financial firm in history, primarily to prevent a host of investment banks from going under.

Now, in the aftermath, we’re recognizing how human nature causes us to make short-term choices that are in direct opposition to our long-term best interests—especially when it comes to money.

Emotion clouds judgment

Rational thought seems to suffer in the face of group-think. It’s hard to go against the crowd, especially when the crowd is saying, “we’re all going to get rich.” It’s equally hard to be contrarian when everyone is paralyzed by fear. And it’s not just AIG, Lehman Brothers and Bear Stern who are susceptible to making bad, short-term choices — it’s any investor. There’s no better proof of this than the annual Dalbar Quantitative Analysis of Investor Behavior (QAIB) report.

Consistent with previous reports, the 2010 study shows the average investor may have underperformed equity markets by as much as 5.03% annually over the 20-year period from 1989 to 2009. And it similarly concludes that investment returns are far more dependent on investor behaviour (often influenced by greed and fear) than on fund performance. Reacting quickly to market changes, investors bought funds when they were expensive and sold them when they went down in value.

Clearly, indices and funds have tended to outperform the average investor not because they’re better investments, but because investors’ reactive emotional decisions tend to overrule the detached analytical synthesis of information that would allow us to make rational investment decisions.

The period leading up to the market peak in early 2008 was in many ways a cycle of greed. Returns were great and everything was on the rise. But once the markets started their tumble in the third quarter of 2008, the high of greed was replaced by fear. There was nowhere to hide and investors couldn’t get into cash fast enough. Investor emotions transformed quickly from manic to depressive.

The role of cash flow

As advisors, it’s our role to stand between investors and their emotions, safeguarding them from the potentially devastating effects of fear-based trading. It’s arguable that no other factor has a greater impact on long-term returns.

Perhaps cash-flow income is what has always made a real-estate investor a less fickle, more assured and ultimately more successful investor than most equity-fund investors. Of course, it’s not that real estate is a better asset, but the value is perceived to be greater due to the income generation of a property, not necessarily the market value. In many cultures, wealth is not measured so much by net worth as by income. This makes sense, since our lifestyle and standard of living are a function of our income (or cash flow).

We’re not intimating here that investment-grade real estate is an inherently superior asset class all the time. But unlike the stock market or mutual fund investor, owners of real estate don’t receive a statement on a monthly or quarterly basis reflecting the value of their property. They have an idea of the market value, but what they really know is the income: the regular inflow of cash to their account.

There are two main benefits to cash flow: (i) it reminds us that we are continually earning money and inhibits us from making rash selling decisions; and (ii) it allows us to reallocate cash to other investments when values may be lower.

Stock market investors, on the other hand, often have no idea what the income generation of their portfolio is. They perceive the value of their investments to be what’s reflected on the bottom line of the quarterly statement.

The advisor’s real value

If most investor decisions are driven by emotion and not reason, it follows that investors should seek guidance in these matters. An objective, reasonable and analytical third party (the advisor) could likely have helped the average Dalbar study investor improve their dismal return.

Many say mutual fund MERs are expensive and erode investor returns. But while fees and costs should be considered when choosing an investment strategy, the real key is a disciplined approach that’s diversified, value-oriented and compels investors to see the advantage in picking unpopular assets when they least want to.

It’s our job to show our clients the nominal fees most professional money managers charge these days (1% or less) is money well spent, particularly when you consider the empirical data suggest that without sound advice, investors may miss out on over 5% per year. Cycles are normal, so it’s important for advisors and clients to work together and manage expectations.

The Dalbar study is not just an analysis of investor behaviour; it’s evidence of human nature. Investors get scared when they see nothing but losses with little to no gains; they panic. Nevertheless, there’s a way to steady the ship: creating a portfolio that includes assets that provide cash flow.

Today, investors are piling into cash and bonds in droves — despite the fact that some great opportunities may now be available. But good investors don’t invest in markets; they acquire specific assets at prices that make sense. Greed has now been replaced by fear, and the hardest thing for an investor to do is take a contrarian stand and not flinch in the face of market volatility.

David Sung is President of Nicola Wealth Management a wealth planning firm serving the needs of high-net-worth individuals and their families.