Stay Far From the 'Mad' Market Crowd <I>After</I> Bubbles

NEW YORK ( AdviceIQ) -- It is always best to remain objective when investing, but the ups and downs of the market can make it difficult to keep your emotions in check.

Charles Mackay's Extraordinary Popular Delusions and the Madness of Crowds recounts the details of several infamous financial crazes, including tulip-mania in the early 1600s, when a tulip bulb was worth more than an Amsterdam house. Obviously, tulips were over-valued. When the market corrected itself, many investors were ruined.

Recently, we have experienced two similar economic cycles with the dot-com and housing bubbles. Overreacting to these boom-to-bust cycles would have made a bad situation worse, hindering financial recovery. Unfortunately, it can be very easy to "join the herd" when times get tough and pull out of the market. That is just human nature. When everyone else is pulling out of the market, there is a natural tendency is to join the crowd.

The trend often is not your friend. An entire academic field, behavioral economics, focuses on human investing foibles. One prevalent fallacy is known as the "recency effect." Behavioral studies show that there's a powerful tendency to believe that what has happened in the past will continue to happen in the future. Should the market drop for two years, the thinking goes, then it will keep dropping forever.

A doctor, whom we will call House, came to me in 2002 at his wit's end. Then in his early 50s, he had loaded up on tech stocks, which since the mid-1990s returned 10% yearly or more. Well, those double-digit dot-com returns turned negative in 2000, and only got worse. Wall Street savants kept saying the market had reached a bottom and would begin ascending again. It did not happen.

"I thought by 2005, with 10% returns every year, I'd be set for life," he told me. "I've been through the ringer."

House had 90% of his portfolio in stocks, mostly in tech and telecom. Everyone was telling him to sell all his stocks and put the money into fixed-income, where at least it would stop shrinking. "My net worth is down by a third," he said. "I need to get out before I lose every last dime. I'll have to work till I'm 75 before I can retire."

It is true that, the older you get, the more conservative you should become. A rudimentary rule of thumb is that the fixed-income portion of your portfolio should equal your age. If you are 55, well, then you should be 55% in bonds, according to this notion. Going to 100% bonds, as House wanted to do, was nuts.

I convinced him to stay in stocks because they were eventually going to turn around. They always do. The age formula is simplistic because investors in his age group still need growth, and especially to recoup from the tech wreck. So in 2003, we shifted his holdings to 65% stocks and 35% fixed-income. The stock portion was no longer tech-heavy. Diversification works best, regardless of the current trends.

Sure enough, his portfolio bounced back and by 2007 he was comfortably ahead of his 2000 peak. You remember 2007? Until the autumn, everyone was giddy over a new boom, this time driven by housing.

House wanted to get more aggressive and latch onto latter-day tulip stocks. I felt that the euphoria had gotten out of hand, just as it had in the late 1990s. It took some convincing, but he grudgingly went along with a 50-50 stock-bond allocation.

In 2008, everything was plunging, stocks most of all. House's more conservative position spared him the pain others experienced, although he still got hurt. Behaviorism teaches that people fear losses twice as much as they love gains. So I got many nervous phone calls from House, where he wanted to ditch the stocks before they went to zero.

I pointed out that, beyond the suffering financial and housing sectors, people were still going to work and companies were not tumbling into bankruptcy. He stayed the course. After March 2009, the stock market rallied and today House is worth millions more than he dreamed possible in woebegone 2002.

He is set. He owes it to turning his back on his emotions.

--By Mike Giammatteo, a principal at Xpyria Investment Advisors in Pittsburgh, for AdviceIQ

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