Institutional Investors Make Two Common Errors
Thursday, September 27, 2012
Charles Rotblut, CFA
AAII Journal Editor

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 36.1%, down 1.4 points
  Neutral: 27.4%, down 1.3 points
  Bearish: 36.5%, up 2.7 points

Long-term averages:
  Bullish: 39%
  Neutral: 31%
  Bearish: 30%

Take the AAII Sentiment Survey »

“Almost three-quarters (74%) of investors say they have changed their approach to risk management in the past five years, and a similar proportion (70%) are more confident that their current approach to risk management is right for volatile markets.”

This is the finding of a recent survey of 482 institutional investors by Natixis Global Asset Management. If the finding doesn’t inspire confidence, that is because it shouldn’t. The numbers show that though most of the surveyed institutional investors thought their previous strategy needed to be changed, they view their current strategy as being the right one. It seems logical that five years ago, those very same professionals thought they had the correct strategy in place.

The data highlights two common behavioral finance errors: recency and overconfidence.

Recency is defined by Merriam-Webster as “the quality or state of being recent.” Behavioral finance describes it as forecasting future events based on recent conditions. If the markets are currently volatile, recency bias causes an investor to believe the markets will be volatile into the future. Eight in 10 global institutional investors told Natixis that market volatility is here to stay. We have seen similar examples in our weekly Sentiment Survey. Bearish sentiment hit a peak of 70.3% on March 5, 2009, literally days before the bear market bottomed out and stocks staged a huge rebound.

The inherent danger with recency is that Mr. Market is a finicky dude. His mood can change quickly and there are never flashing signs telling you that conditions are suddenly different.

Among the phrases Merriam-Webster uses to describe confidence is “the state of feeling sure.” Though beliefs in one’s ability to pick good investments and manage a portfolio are important, having too much confidence can be dangerous. This is particularly the case when a specific outlook is adopted (e.g. stocks will fall by more than 20% over the next six months) and a portfolio is managed accordingly. We have seen many famous cases of overconfidence (defined as “excess of confidence”) leading to disastrous financial results. Surely, the people running Bear Stearns and Lehman Brothers thought their firms were not at risk of collapse.

Confidence can also harm an investor when someone else is expressing it. In “The Little Book of Behavioral Investing” (John Wiley, 2010), James Montier discusses studies that show perceptions are affected by how confidently a viewpoint is expressed. A person stating an opinion with enough confidence can get others to believe him, even if his viewpoints are wrong. We see this in investing where bold forecasts attract followers. Calling for a calamity or a raging bull market is a great way to sell books and newsletters, but following such forecasts is rarely a good long-term investing strategy.

These errors show why it is important to think long term and not abandon a good, balanced investment strategy. There will always be suggestions that things are different this time. Shorter-term market moves will make a long-term strategy appear to no longer work properly. Over long periods, however, short-term strategies often fail, while those investors who stick to their long-term strategies often prevail. This is why you should always be careful not to let your allocation be determined by short-term events or charlatans disguised as so-called experts.

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The Week Ahead

Just a handful of S&P 500 companies are on the earnings calendar. Mosaic (MOS) will report its results on Tuesday; Family Dollar Store (FDO), Marriott International (MAR) and Monsanto Company (MON) will report on Wednesday; and Constellation Brands (STZ) will report on Friday.

The week’s first economic reports will be the September ISM manufacturing index and August construction spending, both published on Monday. Tuesday will feature September motor vehicle sales. The September ISM non-manufacturing index and the September ADP Employment Report will be published on Wednesday. Thursday will feature the minutes from the September Federal Open Market Committee meeting and August factory orders. September jobs data, including the unemployment rate and the change in nonfarm payrolls, will be published on Friday.

The first presidential debate will be held on Wednesday. Just 40 days from today until the campaign ads and phone calls stop.

October has the reputation as being the worst month of the year, thanks to the 1929 and the 1987 crashes. The month is not as ghastly as its reputation suggests, however. According to the Stock Trader’s Almanac, since 1950, the S&P 500 has 36 October gains and 25 October losses. The month’s average gain of 0.6% ranks as the seventh best.

AAII Sentiment Survey

Bearish sentiment rose to its highest level since July 26, 2012, in the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stock prices will rise over the next six months, declined 1.4 percentage points to 36.1%. This is the fifth consecutive week and the 25th out of the past 26 weeks that bullish sentiment is below its historical average of 39%.

Neutral sentiment, expectations that stock prices will remain essentially unchanged over the next six months, fell 1.3 percentage points to 27.4%. This is the third consecutive week that neutral sentiment is below its historical average of 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose 2.7 percentage points to 36.5%. Pessimism is now at a nine-week high. Bearish sentiment is above its historical average of 30% for the fifth consecutive week and for the 21st time in the past 25 weeks.

Even though bullish sentiment remains below average, optimism among individual investors remains improved relative to what was registered throughout spring and much of the summer. While bearish sentiment is now at a nine-week high, it is below the May through July readings. Splitting the moods of AAII members are higher stock prices, improved economic data, slowing global economic growth, Washington politics and the European sovereign debt crisis.

This week’s special question asked AAII members how the likely forthcoming adjournment by Congress without a deal to avert the fiscal cliff influences their six-month outlook toward stocks. Respondents were nearly evenly split between those who said their sentiment is not affected and those who said it makes them more cautious or more bearish. Several members said their sentiment is not affected because they thought the politicians will reach an agreement to avert the fiscal cliff. Many members expressed frustration, cited the current uncertainty or are awaiting the outcome of the November elections.

Here is a sampling of the responses:

  • “It doesn’t influence my sentiment, but it sure makes me irate at our government.”
  • “I think Congress will kick the can down the road, so the fiscal cliff is unlikely.”
  • “The lack of a solution will lead to significant uncertainty and apprehension, causing a pullback in the stock market.”
  • “Stocks will drop if nothing is done to resolve the fiscal cliff.”
  • “I will forgo any major stock purchases until the fiscal cliff issue plays itself out.”
  • “My outlook remains the same—long-term investing regardless of the political idiocy of the moment.”

» Take the sentiment survey

Wishing you prosperity,

Charles Rotblut, CFA
AAII Journal Editor