For Better Investment Results, Think Like a Rat

Each time the Dow Jones Industrial Average drops more than a point or two, many media outlets claim the market has reached its peak and urge investors to pull out before a correction hits. 

Our advice to anyone considering this move? Turn off the TV and start thinking like a rat. That’s right—if investors adopted a rat’s mindset, they’d likely see much better long-term results.

Red Light, Green Light

The evidence comes from behavioral psychology. In 2002, researchers conducted a study where participants were rewarded for 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 rant tests on both rats and humans. When the rats guessed correctly by pushing the corresponding button, they were rewarded with food. If they were wrong, they received a mild electric shock. Remarkably, the rats quickly learned that the green light flashed more often, adapted their behavior, and chose green every time. They willingly chose the occasional shock, making them correct 80% of the time. 

The human subjects also noticed that the green light flashed more consistently. However, their behavior was quite different from the rats’. Instead of choosing green every time, as the rats did, people tried to predict when the red light would flash. In their effort to find a pattern in the random flashes, humans were correct just 68% of the time.

The Illusion of Control

It seems that humans are simply hardwired to make poor decisions in situations like this. This explains why many investors continue to try and time the market, despite the evidence showing that no one has consistently done it right.

Take the 2000-2002 tech crash and the 2008 financial crisis. In those tough bear markets—precisely when market-timing strategies should theoretically shine—the data shows that even the pros had a hard time making it work.

Mark Hulbert, who has tracked market timers since 1980 through his Hulbert Financial Digest, found that only 11 out of 81 market-timing advisors made money during the 2000–2002 bear market. However, these “winners” performed so poorly in the years that followed that, over a 15-year period that included the tech crash, they lost 0.8% annually. Meanwhile, a simple buy-and-hold strategy gained 4.2% per year.

Vista’s own study of the 2008 financial crisis found that 89% of “tactical allocation” mutual funds underperformed a steady mix of 65% stocks and 35% bonds. In other words, just when investors would have wanted a savvy fund manager to protect them from a 38% stock market loss, the pros actually performed worse than a basic buy-and-hold approach.

Fortune Favors the Rats

Why do market timers tend to perform so poorly? It might be because they strive to be right all the time. Ironically, their constant attempts to predict the future and outsmart the market’s day-to-day variations often lead to worse results.

Rats, however, take a different approach. They accept that they’ll be wrong sometimes and focus on minimizing those errors. By sticking to a disciplined strategy, they maximize their chances of being right more often.

In today’s world, it’s easy to find reasons to pull out of the market. Just turn on the news or pick up a newspaper. But the evidence shows that abandoning a buy-and-hold strategy usually leads to worse outcomes.

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