Emotional Nevolution

When it comes to investing, we human beings are an undisciplined bunch. We over-concentrate in a handful of companies, chase heat, prefer the familiar and let emotions chase us in and out of stocks. As a result, few of us can achieve anything close to market-like returns.

And so we’ve been since the dawn of equity markets, according to a new study highlighted in The Wall Street Journal. Using share registries of publicly traded companies on the London exchange from 1690 to 1730, researchers traced every purchase and sale of the day’s dominant firms—and every buyer and seller. Their findings? Our ancestral investors were horribly under-diversified—86% owned only one stock. They also chased heat, trading more as prices rose, and underperformed London’s fledgling equity market.

Now, to be sure, fewer companies were traded then, and some folks likely concentrated for the perception of prestige (something that likely still happens to this day). At the same time, this prestige was likely cold comfort to those who lost everything during the South Sea Bubble, when shares of the South Sea Company fell from around £900 in August 1721 to practically nil the following spring. (Near simultaneously, their French counterparts were fairing little better, getting caught in 1720’s Mississippi Bubble.)

Overall, the behavioral similarities between 18^th century and today’s investors are staggering. Modern investors in individual stocks aren’t much more diversified—they can count their average number of holdings on one hand. Then, like now, many investors shunned fundamental analysis, paying scant attention to conditions impacting the broader market, economy or other major drivers.

Investors who use mutual or index funds may have better diversification, but they’re not immune to behavioral pitfalls. Undisciplined trading—as prevalent today as in 1700—strikes fund and individual shareholders alike. Even the smartest, most rational people can fall prey to emotion in investing, no matter their intentions to buy and hold a fund. Fear and greed lead many to trade too often, at the wrong times.

Hot markets are seductive—and markets look hottest when they’re peaking. How many investors doubled down on the Nasdaq in 2000? Or piled into Energy in 1980? Fundamentals indicated these markets would soon turn, but euphoric investors couldn’t or chose not to see reality. They saw dollar signs, not exit signs. Fear is perhaps even more dangerous. Rapidly falling markets are scary, and selling out when stocks drop sharply might feel better or safer. But volatility—even extreme volatility—is normal during bull markets and impossible to time with any certainty. Corrections frequently come and go, most often with little rhyme or reason behind their entry nor their exit. Investors who try to avoid corrections often sell near the bottom and don’t buy back in until stocks have bounced—locking in losses, paying trading costs and missing opportunities.

Emotion makes investors buy high and sell low. Many fall prey repeatedly, in corrections and bear markets alike. They forget the S&P 500’s averaged 9.7% a year (annualized) since 1926, despite every correction and bear market along the way. Simply staying patient and focused on their long-term goals throughout volatility would help equity investors get market-like returns over time. But most investors can’t stay patient, leading to vastly inferior long-term returns. According to market research firm DALBAR, from 12/31/1991 through 12/31/2011, equity investors who used mutual funds earned an average annualized return of 3.49%—less than half the S&P 500’s 7.8%. When volatility is high—whether stocks are rising or falling—investors rarely guess right. Or, as DALBAR concluded, “investors fail at timing the market.”

Success in equity investing requires discipline and patience. That’s as true today as it was in 1700—though it’s probably about as often ignored. Simply, human behavior hasn’t evolved much in 300 years and, as it pertains to markets, many investors’ ancestors mistakes are often their own. Market savvy certainly helps, but even the most sophisticated investors must fight emotion daily. This might seem near-impossible in the age of smartphones, Twitter and 24/7 cable news—at every turn is another piece of news or another glimpse of the market’s daily volatility to set your pulse racing. But investors who can think longer-term, filter the noise, ditch their biases and rationally determine what will and won’t impact stocks will understand what most people can’t: While there are times to buy and times to sell, very often, the right decision is to take a deep breath, stay patient and do nothing.

Global Financial Data, Inc., as of 02/02/2012. Annualized S&P 500 returns January 1926 – December 31, 2011.