Teach yourself to become a better investor--Part 2

Jason Zweig's latest book, Your Money and Your Brain, looks at how the brain responds when making real-life financial decisions. In an interview that appeared on Morningstar last month, Zweig, who writes The Intelligent Investor for The Wall Street Journal, shared some tips for overcoming your brain's worst impulses. In part two of that interview, he shares some wisdom for making good decisions during times of financial crisis.

Investors' short-term memory
Christine Benz: How has the recent bear market corroborated some of the findings in your book? Or not?

Jason Zweig: Let's think back to October or November of last year or March of this year, when the Dow seemed to be headed toward 6,000, and people were just terrified. There's no doubt that millions of investors, both retail and professional alike, were acting out of sheer uncontrolled fear. And the level of stress that investors felt was unbelievable. And when people are afraid, and when you're feeling stress, not stress in the pop psychology sense but stress in the physiological sense, when your blood pressure goes up, you're sweating, your heart is racing, your hands are shaking, you can't sleep, and you're on the verge of depression, and you're snapping at your family and kicking your dog, people make bad decisions. And they make impulsive decisions, they make big decisions when they should be making small ones. Instead of making incremental adjustments to portfolios, instead of rebalancing at the margin, people bailed out of asset classes entirely or just moved completely into cash. The other thing that neuroeconomics suggests goes on in people's minds in a time of market panic is the automatic perception of illusory patterns--detecting "trends" in random data that simply are not there. Things that seem to be predictable loom much more important in people's minds. People develop a belief that the future is more knowable. That's stronger in a time of extreme uncertainty.

So what was I seeing in my e-mails were hundreds of messages from people about how the world was coming to an end, quite literally. "We're going into another Great Depression." "The financial markets will cease to function completely." "I'm stocking up on granola bars and bottled water and extra cartridges for my gun." I got any number of "I'm going off the grid" e-mails. And the thing that's surprising to me is not that all of that happened, because that's exactly the sort of thing I would have predicted. What has surprised me is how quickly the mindset has shifted. And now it seems that people have completely forgotten how they felt a few months ago. And that's very troubling to me. It suggests to me that we're nowhere near out of the woods. I do not tend to make market forecasts of any kind, but that worries me so much that I think we're probably in for another big surprise before we have a full recovery.

Benz: One thing I was glad to see you touch on in your column was the renewed stampede into emerging markets.

Zweig: There's been an enormous amount of performance-chasing. Part of it is that humans are a hopeful species. We do want to believe that the worst is behind us and that happy days are here again. People took a terrible beating at the end of 2008 and the beginning of 2009, but we're optimists and we all want to believe that's behind us now. And because of that, people are already doing some very foolish things that they will come to regret later, I think.

Making good decisions under stressful conditions
Benz: So how can we learn to make better decisions in times of financial turmoil?

Zweig: One thing that's really important is the concept I've taken to calling the financial fire drill, which both individual investors and especially financial advisers could benefit from. Maybe we don't need it as much as we did back in 2006 or 2007, but then again, maybe the speed of the market recovery suggests it's a good idea. Essentially, you deliberately create an environment that makes rational decision-making difficult. So, for example, if it's the summer you would turn off the air conditioning; if it's the winter you would turn off the heat. You would close all the windows and doors so you cut down on the oxygen level in the room. You put Jim Cramer in an endless loop on the television, maybe pump in the sound of a crying baby or ambulance sirens, filling the room with noises associated with stress. And then you would have maybe a red light flashing. And all of these things are scientifically proven to elevate stress, and of course we all know just from common sense that it's tough to make a decision under conditions like that.

And then you would present your client or the financial adviser team would present each other with a series of portfolio decisions. "What should we do? GE stock has gone from $60 to $5." or "The market is going down right now. What do we do? We said we wanted to have 75% in US equities, and the market is down 60% since we made that decision. What do we do?" Or "This particular asset seems really cheap, should we buy it?" You need to consider those decisions while the lights are flashing and the bells are clanging and CNBC is full of red arrows pointing downward and all the stock charts are going through the floor. You have to come up with a way of calmly arriving at a decision that makes sense. And I think one of the ways you need to do that is that you need to imagine the future. And you need to frame the decision as "Let's make sure we do something today that we won't regret six months, a year, five years from now."

And the nice thing about this kind of exercise is that it's practice for the real world. Because as we saw last autumn, and this past spring, that's what it was like. And people made decisions every day under those circumstances, and a lot of those decisions were bad, because people had never been in circumstances like that before.

I would close this observation with a reminder to everybody, which is now part of American folklore. Think of Sully, the famous captain of the US Air flight bringing his plane down into the Hudson River and having every single passenger survive. What enabled him to do that? Not his superior knowledge, not knowing more about his airplane, or the Hudson River, than anybody else. What enabled him to do it is practice. And if you've never really practiced what it's like to make a decision in a global financial panic, you can make panicky decisions in a global financial panic, and you'll crash your plane and you'll kill everybody. But if you've practiced how to stay calm and make a good decision, you stand a better chance of being able to do it. Repetition is the key to calmness.

Is buy and hold dead?
Benz: I'm certainly hearing from a lot of investors--and this has been going on for the past six to nine months--"Asset allocation is dead. Strategic asset allocation is dead, tactical is the way to go, and what can you do to help me with tactical asset allocation?" What do you say to that way of thinking?

Zweig: This is the $64 trillion question. In some ways, it's the only question that matters. Everything hinges around this. My view is that it's not dead. I think people have confused a whole bunch of factors. One, people really misunderstood what diversification means. People thought diversification means that if you combine uncorrelated assets you end up with a portfolio that won't go down in value. And that's not what diversification means. First of all, you're not diversified unless you own something that hurts to own. And the second thing is, we have hundreds of years of data on financial markets of various kinds around the world. So far as I know, there's never been a financial crisis in which correlations didn't go up. In fact, they tend to go all the way up, to 1.0, the same way they did in this one.

And common sense should tell you why that's probably true. At a time when it seems the whole world is going to hell in a handbasket, everything goes down. That's what happened this time, that's what happened in 1973-74, it happened in 1929, it happened in 1907, it happened numerous times in the 19th century, and as far back as you care to go.

So diversification is really powerful, but it's not magic. It doesn't raise people from the dead, it doesn't enable you to levitate entire buildings up off the ground. It's a very good thing but it doesn't work miracles. So that's a problem I have with this argument. When people say diversification failed, they're defining failure in a very strange way. They seem to be saying if, when most assets went down, something didn't go up, then diversification didn't work. And that's not what it ever meant. All it ever meant is that if you have assets that are statistically not highly correlated, putting them together will give you a better trade-off of risk and return.

If you look at what happened in the financial crisis, that's what you got. People who owned some stocks and some bonds did better than people who owned all stocks. People who had some other assets in there did better still. The fact that the US market went down 37% and foreign stocks and emerging markets stocks went down also doesn't mean that diversification didn't work, because they didn't all go down exactly 37%. Diversification did work for exactly that reason--you got different rates of return. People want diversification to produce a positive return out of some asset when their favourite asset is down. But there are no guarantees. Diversification isn't a form of insurance, it's just a form of risk control.

The final point I would make is what all of this reminds me of is what you hear out of ignorant sports fans. Someone might say, "Carmelo Anthony, he stinks. He's not as good as LeBron James. LeBron is so much better." But that doesn't mean that if you tried going one on one with Carmelo Anthony, you'd outscore him. The problem with this whole "asset allocation is dead" argument is--let's just assume for the sake of argument that asset allocation is dead--what's alive? Where is the long-term evidence with thousands upon thousands of data points over many many years and multiple markets, with real money invested--not backtested--where is the evidence that something else has worked? Asset allocation hasn't worked in certain years, but nothing else has either. That's the problem I have with this whole debate, which is it's easy to say what hasn't worked well lately, but it doesn't mean that all the things that never worked have suddenly started to work.

Minimising human error
Benz: I'd like to get your perspective on indexing. Why do you favour that approach and believe it makes sense for most investors?

Zweig: I've never actually done a count, but I'm sure there are well in excess of 100 independent reasons. The first is that human life is finite, so if I find a manager I love, I have to ask myself if he or she still going to be around in 30 years when I retire or 100 years from now when my kids or grandkids inherit my shares in this fund, and what confidence do I have that he's as good at picking successors as he is at picking stocks? That would be the first.

The second is the tax efficiency argument, which is very powerful. In a taxable account, it's hard to argue for active management at all. If an active manager is doing his or her job and being active, then capital gains are going to be generated. In fact, the better a person is at doing his or her job, the larger those gains are going to be over time.

Another is that indices minimise some of the worst aspects of human error. Think about the most terrible bond-fund blowups of 2008: the Oppenheimer Core Bond Fund or the Schwab YieldPlus fund or those Regions funds. In the case of short-term bond funds in particular, a lot of the managers just yielded to the temptation of chasing yield and putting in a lot of mortgage garbage because they could goose the yield. If you bought a short-term bond index fund, you just didn't get that sort of thing. There are short-term bond ETFs, and none of them blew up because the computers--the machines--didn't have much interest in mortgage derivatives. The humans running active funds, on the other hand, were hell-bent on earning a bonus based on how much yield they could produce.

I guess the overriding point is in my opinion it's extraordinarily difficult to pick individual securities that will outperform a market benchmark, but I happen to think it's even harder to select managers who will outperform a category average. I think that's even harder, and it's harder because you have all kinds of second-order effects. You have asset growth, you know, "This person was great when he was managing 200 million bucks, but now he's got $10 billion. Is he still going to be able to do it?" Well, who knows? If you ask him he will say he will, but asset growth can kill performance. Then maybe he's made so much money he's fat and happy and just wants to spend some time on his yacht. And if you ask him, he's going to tell you, "No, that's not true, I'm still hungry."

It's extraordinarily difficult to pick a great manager who will still be great. And the most basic reason for it of all is that luck is really the driving force, to the extent that most investors don't appreciate and can't appreciate because it makes people uncomfortable, but it happens to be true.

I'm not saying that active management is bad or futile, or that I think everyone who invests in an actively managed fund is an idiot. What I am saying is that it's extraordinarily hard to get it right, and maybe the best reason of all to do it is if you can find a manager whose view of the world is really similar to your own. Because then you're a lot more likely to go along for the ride. Like Morningstar, for many years I've been almost obsessed with the concept of dollar-weighted returns as opposed to the time-weighted returns that everyone reports. And all the arguments in the fund business and among financial advisers are really about basis points, is this better than that, is this kind of fund better than that kind, is active management better than passive management? But the real debate should be about percentage points, not basis points. And the percentage-point-gaps are the gaps between the returns of the investment and the returns of investors. One really good way to close that gap is to get people into funds that make them comfortable. A charismatic, eloquent, dynamic, confident active manager is someone you might be able to be loyal to when you can't be loyal to a computer program. Index funds don't have personalities, and they can't write much of a letter to their shareholders. A great active manager can be a magnet for loyalty, and that's really important. And I would never denigrate that, and in fact, most investors would probably be better off putting their money into a mediocre fund they could be loyal to than a whole series of great funds that they go barging in and out of at the worst possible times.

Christine Benz is Morningstar's director of personal finance.