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Investor behavior redefines “dogs of the Dow”

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A couple of years ago, I arranged to purchase an eight-week old beagle for my wife’s birthday. She named him Wally. Actually, she named him Wally about four decades ago when she first dreamed of having a beagle named Wally. Once Wally got his land legs, I soon found him doing the thing all dogs do. For no apparent reason, he would chase his tail. Everyone in the family thought it was so cute. Incredibly naïve, but cute.

Believe it or not, people who study these things call it “dog compulsive behavior.” This is similar to the human “obsessive compulsive behavior.” If we’re to believe a recent study, one of the primary examples of obsessive compulsive behavior in humans is their uncanny ability to consistently chase investment performance (see, “Why 401k Investors Chase Performance – and How to Prevent It,”, March 5).

We can attribute this unhelpful behavior to a couple of reasons. First, quite simply, there’s greed. Despite all the plaintive warnings required by the SEC, too many investors — including ERISA plan sponsors — genuinely believe past performance guarantees future performance. How else do you explain all those sophisticates taken in by Madoff?

Besides greed, though, is a common behavioral sin. This one’s called “recency.” It’s a bias that pervades our culture. It’s why many people think Joe Montana is a better quarterback than Otto Graham. It’s why the average teenager goes gaga over Justin Timberlake but offers only a blank stare at the mention of Frank Sinatra. It’s why today’s politicians get their names on buildings formerly named after founding fathers. All of us place a greater value at things we’ve experienced recently. This generates a recency bias. And this, in turn, often leads to bad decisions.

Take, example, 401(k) plan sponsors. As the above link explains, studies have shown 401(k) plan sponsors routinely dump poorer performing plan options and replacing them with better performing plan options. The trouble is, of course, they’re only looking at the last three years of performance. They fail to take into account the normal investment cycles. And guess what happens? Invariable, those new funds underperform the replaced funds as everything regresses to the mean over the next three years.

Investing is not for the faint-hearted. It requires a stern discipline. If investors don’t have it, they will end up chasing performance — and their portfolios will suffer as they buy at the top. It takes a lot of courage to sell at the top and buy at the bottom. But, what else would you rather do? Sell high and buy low? There’s a reason why the Dogs of the Dow strategy works — and it has nothing to do with obsessive compulsive behavior. And that’s no tale.

For more from Chris Carosa, see:


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