For Better Investment Results, Think Like a Rat

Since its March 1 peak, the widely-followed Dow Jones Industrial Average has fallen 2.3%. Some in the media have suggested the market has topped out and investors would be smart to get out now, sidestepping what could be a looming correction.

Our advice to those tempted to do so? Turn off the TV and start thinking like a rat. That’s right, if investors behaved more like rats, they’d have much better long-term results.

The evidence comes from behavioral psychology. Back in 2002, researchers conducted a study in which subjects were rewarded for correctly predicting whether a green or red light would flash next. The experiment was controlled so that the green light flashed 80% of the time, and the red light 20%, but in random order. Incidentally, this is just how stock prices have historically behaved, delivering gains in roughly four out of five years.

The researchers ran their tests on rats and humans. If the rats guessed correctly by pushing the corresponding colored button, they were rewarded with food. If they were wrong, they received a mild electric shock. Remarkably, rats quickly recognized that the green light flashed more often, adapted their behavior and chose green every time. They willingly accepted the occasional shock and, as a result, rats were correct 80% of the time.

The human subjects also recognized the green light flashed more consistently.  Their behavior, however, was quite different. Rather than choose green every time, as the rats did, people tried to predict when the red light would flash. In their effort to identify a pattern in the random flashes, humans were correct just 68% of the time.

It seems, then, we humans may simply be hard-wired to behave poorly. This explains why so many investors remain intent on trying to predict the right time to get into and out of the market despite the evidence telling us no one has ever done so consistently.

Consider the 2000-2002 tech crash and 2008 financial crisis. During these difficult bear markets, precisely when a market-timing strategy might shine, the evidence suggests it is a losing proposition, even for the pros:

  • Mark Hulbert, who since 1980 has studied market timers via his Hulbert Financial Digest, found that just 11 of 81 market-timing advisors made money during the 2000-2002 bear market. Those “winners,” however, did so poorly in the good years that followed that for a full 15-year period including the tech crash, they lost 0.8% annually while a buy-and-hold approach gained 4.2% per year.
  • Vista’s own study of the 2008 financial crisis revealed that 89% of “tactical allocation” mutual funds underperformed a hold-steady mix of 65% stocks and 35% bonds. That’s right, just when investors would have wanted a prescient fund manager to protect them from the 38% loss in the stock market, the pros performed worse than a basic buy-and-hold approach.

Why do market timers perform so poorly? The answer may lie in their desire to be correct all the time. Ironically, their efforts to predict the future and outguess the random day-to-day variations in the stock market leads them to perform worse.

Rats, on the other hand, accept the fact they will be wrong part of the time. To minimize the incidence of such errors, they adopt a disciplined strategy which ultimately maximizes the likelihood of being correct.

Today, it is easy to find reasons to believe getting out of the market is the right thing to do. Just pick up any paper or turn on the TV. The evidence, however, tells us switching from a buy-and-hold approach is more likely to result in worse results.

Indeed, the odds favor investors who—like rats—adhere to the best long-term strategy and accept the fact there will be a few temporary shocks along the way.

 

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