[This blog was originally published by Summitas at www.Summitas.com]

We don’t have to observe investor behavior for very long before concluding that human beings are hard-wired for investment failure. Large fortunes tend to disappear entirely in three generations. During Bull Markets investors lose all sense of perspective and load up on increasingly risky equities, as though prices could never go down. During Bear Markets investors give in to despair, selling out near the bottom, apparently convinced that equity prices are going to zero. Investors chase returns, piling into whatever sector or manager is hot, ignoring research showing that return-chasing behavior always ends in tears.

There is even an entire field of study – behavioral finance – devoted to the detailed analysis of how and why investors fail. Exotic-sounding concepts like “loss aversion” are really just academic jargon for investor behavior we see every day. These so-called “cognitive biases” lead us to behave in ways that are irrational, that is, that lead us into taking actions that are against our own interests.

It’s very important for investors to recognize that we are optimized for wealth destruction, especially at inflection points in the capital markets (Bull and Bear Markets). In effect, we seem condemned to own exactly the wrong portfolios at the peak of Bull Markets (i.e., too many stocks) and at the nadir of Bear Markets (not enough stocks).

The sequence of investor behavior always (always!) follows this pattern: as prices rise, investors enter a period of over-confidence, allowing equity exposures to exceed prudent levels. As more and more investors pile into the markets and brag about their great returns, “herding” behavior causes investors to own even more equities, as there now appears to be safety in numbers. Then, as prices begin to fall and wealth destruction takes hold, investors panic – at first individually and then, again, as a herd. Prices fall further and further and investors proceed to immortalize their losses by selling out. Compounding this first round of wealth destruction is the next step in the pattern, where risk seeking behavior has atrophied completely. Hapless investors, now sitting firmly on the sidelines (in cash), watch helplessly as the portfolios they used to own rebound powerfully. By the end of this cycle, capital has been destroyed on a massive basis.

What is it about human beings, who in other aspects of their lives are capable of making rational decisions, that causes such wealth-destroying behavior? John Maynard Keynes once remarked that “markets are almost, but not quite, rational.” True enough. But human investors are also almost, but not quite, rational. To be successful as investors we can’t allow our emotions to dictate our actions. But this is very, very hard to do.

Here, for example, is how investors should behave: When stocks are cheap – near the bottom of Bear Markets – we would be near the top of our target equity range. When stocks are expensive – near the top of Bull Markets – we would be near the bottom of our range. When everyone else is buying, we would be sellers; when everyone else is selling, we would be buyers.

But ask yourself, is this the behavior you observe in other investors? Is it the behavior you observe in yourself? Of course not. If anything, we tend to do exactly the opposite. Human beings are rational, but not always: our decisionmaking is clouded and corrupted by our emotions. And the more powerful those emotions are – and greed and fear are right up there at the top of the heap – the worse our decisionmaking will be. We are optimized for wealth destruction.

Next up: In my next blog, we’ll look at ways to minimize the destructive role of emotion-driven behaviors in our portfolios.

Please note that this article is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.

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