One of the concepts I often use during the financial education portion of my client meetings is the idea of the emotional investor. We all know the classic investment adage: buy low and sell high. The concept of making money on an investment is simple. Yet study after study shows that investor behavior frequently guides them to do the opposite. They flood the market when times are good (effectively buying high) and flee the market in droves when times are bad, thus selling low. Emotions have driven them to the inverse of the classic investment adage - a proven and surefire way to destroy wealth over time.
In fact, the 2016 Dalbar QAIB study on investor behavior , found that for the 30-year period running from 1985 to 2015 the average equity investor earned a return of 3.66%. During the same period the market (as measured by the S&P 500) returned an average of 10.35%. That’s an underperformance by the investor, on average, of nearly 7%! If I told you my firm’s investment strategy was to underperform the market average by nearly two-thirds for 30 years no one would want to invest with me. Yet, that is exactly what many investors do when they go it alone and fail to follow an investment strategy.
I make it a point to speak on this topic often because I believe it is one of the most important concepts for a prudent investor to grasp. It is key to achieving long-term success in investing. Typically, during our meeting, the client nods sagely as we amuse ourselves with the notion of the foolish investor, who allows emotions to drive him to make the wrong decision at all the wrong times. “How foolish of them,” we both think, “it’s a good thing I’ll be able to see these emotionally-driven moments and avoid them in my own life.” And yet emotions are a tricky thing. Try as we like it is impossible to remove them from the equation of investor behavior. The sneaky thing about emotions in our investment decisions is they’re very difficult to recognize in the heat of the moment. In fact, the very concept of waiting to buy low and sell high often runs contrary to our human nature. It frequently means buying the stuff that no one else wants and passing on perceived treasures that sparkle at us when we pass by.
A fascinating case study into this human psychology is the recent bitcoin phenomenon. Now, let me preface this by saying I have no idea what bitcoin is going to do in the coming months, years, or decades. Part of my belief in passive investing philosophies is that much of this is inherently unknowable, and even unimportant, to the long-term strategy of a prudent investor. In 2017, bitcoin rose to a value of $19,706 in early December before finishing the year at $13,912 (a decline in value of close to 30% in a single month). It may be headed for $100,000 in 2018 and it may just as well be headed for $0. My point in this article is not about the soundness of bitcoin as an investment but rather the investor behavior surrounding it.
Starting around the fall of 2017 bitcoin suddenly caught fire, going from around $4,000 in late August to close to $7,500 by early November. The news cycle was dominated with stories about bitcoin, with purported experts on both sides shouting about the upside or downside of investing in bitcoin. Suddenly, my inbox was filled with client emails, “What are your thoughts on bitcoin?” and “How much could I pull out of my portfolio to put into cryptocurrencies?” In many cases, these individuals were only a few weeks or months removed from our consult conversation about the unwise emotional investor, but still the emotions of bitcoin fever suddenly had them fully in its grasp.
Let’s revisit the classic market adage: buy low and sell high. Bitcoin began 2017 valued at around $1,000 and had reached close to $5,000 in the fall when the fever really struck, ending the year close to $13,000. At which point in the year would you have been buying low? When would you have been buying high? Yet it wasn’t until after bitcoin had gone on its meteoric rise that almost everyone – from the news cycle, to my Facebook friends, to my clients – got excited about it. Suddenly bitcoin was the shiniest object on the block, alluring with something almost impossible for the human psyche to resist: the opportunity to get rich quick, the easy way.
But now we have the benefit of hindsight – spotting adverse investor behavior is easy in hindsight, remember? Looking back, if you had followed your gut and invested in bitcoin on November 15th 2017, (at the height of the bitcoin fever) your rate of return between that date and the start of last month, August 1st 2018, is right at zero. If you had purchased a month later on December 15th 2017, your rate of return is -56%. And yet trading volume in bitcoin surged to an all-time high in the week surrounding December 15th 2017. On August 1st of 2017 there were 132,000 bitcoin transactions per day, by December 15th there were nearly 500,000 transactions per day. That trading volume surged again in late December, when bitcoin plummeted -38% in a span of a few days. Following their guts, investors surged into the market when the price was at an all-time high only to flee the market when it crashed a few days later.  I’ll say it again – as human beings our emotions make us really good at buying high and selling low, taking a wrecking ball to our chances of wealth creation along the way.
This is the concept that is most important to understand about the emotional investor making adverse investment decisions: they’re usually going with the flow of what is “hot” in that moment. The masses were hot on the stock market in 2007, leading many to take unwise risks in the pursuit of investment gain oftentimes at the recommendation of the news cycle. Those same masses were out on the market at the end of 2008 and the following year, having been stung by a painfully steep bear market drop. Many investors then missed the meteoric rise of the stock market from early-2009 to 2010 and only jumped back in once the market had shown sustained growth and the masses regained their confidence. For those keeping score at home, that’s bought high in 2007, sold low in 2009, bought high again in 2010. But in every case, you could have justified your actions at the time because of what the media, your wealthy uncle, or your Facebook friends were all saying. Investor emotions are easy to sort out with hindsight, but difficult to recognize in the moment.
So, here’s my advice: invest in bitcoin if you want to, but follow the rules of speculative investing. Before you chase whole-heartedly after bitcoin or any investment that might turn out to be just a fad, I recommend you pause to ask yourself if you truly believe in the fundamentals of the investment you’re making or if you’re simply chasing what is shiny. It turns out some of what shimmers brightest is only fool’s gold.
 “Quantitative Analysis of Investor Behavior, 2017,” Dalbar, Inc. www.dalbar.com
 SOURCE: charts.bitcoin.com