Humans Ability to Manage Risk Considered Overrated

We are two years away from the March 9, 2009 low on the S&P of $676. Today it stands at $1,304. As you ponder the latest paean to risk management as the bastion of level headed, rational approach to infsoec consider what Jason Zweig recently wrote about Sheepish Bulls

In speaking with financial advisers around the country over the past couple of weeks, I heard two frequent refrains. First, most small investors have been extremely cautious in adding to their positions, even as the stock market has doubled since March 2009.

Second, and more troubling, many of the investors who are aggressively getting back into stocks are the very same people who fled the equity markets in the fourth quarter of 2008 and the first quarter of 2009, just before it embarked on a historic rally.

"I think these clients are embarrassed to a certain extent," says Owen Murray, director of investment research at Horizon Advisors, a money-management firm in Houston. "The ferocity of their desire to get back in now doesn't nearly match their desperation to get out [in 2008 and 2009]. It's more like a kind of capitulation."

These are the sheepish bulls—people who know they sold low two years ago and worry that they are buying high today. In some cases, financial planners say, these clients are asking to hold even more in stocks than they did before the market crashed.

...

Dennis Witte, 73 years old, a retired engineer for Eastman Kodak who lives in Conesus, N.Y., with his wife, Charlotte, had about 62% of their money in equities going into the financial crisis. As 2008 progressed, "we were really scared," Mr. Witte recalls. By that September, after their stock investments had lost more than a third of their value, "we finally decided we'd had enough."

Over the past few months, the Wittes have moved back into stocks. "I'm back to about 40% equities," Mr. Witte says, "and I want to be at more."

Does he worry that, having bailed out near the bottom, he may be getting back in near a top? "That's certainly a good question. I suppose some might call us foolhardy," Mr. Witte says. He adds, "We don't have any regrets. I think the market is there to protect what you have when you're a retiree. It doesn't mean when things are imploding you have to sit there like a doofus."

Once bitten, twice bold: What turns yesterday's sellers into today's buyers?
The sheepish bulls seem to be driven by what psychologists call "counterfactual regret"—the haunting sense of what might have been. "These investors have been double-traumatized," says Michal Strahilevitz, a business professor at Golden Gate University in San Francisco who studies how investors behave.

"First in 2008 and 2009, they suffered until they said 'I can't take it anymore' and sold all their stocks," she says. "And now they've had to deal with the trauma of watching the market go up and realizing that they'd be better off if only they hadn't gotten out."

Think about that for a minute. People who were selling around 700 and perfectly ok buying at 1,300. They are not buying because the price is a bargain, but rather because everyone else is. 

Its the equivalent of no one got fired for buying IBM, you might waste a lot of your company's money by overinvesting in Network Security because everyone else is doing it, but in the financial world you can lose a lot of your own money with this kind of behavior. Say you started with $100 pre-crash, you got scared into selling near the bottom so your $100 turned into $60. How is buying back in with your smaller amount of capital at a higher price going to help?

As Warren Buffett put it - you pay a very high price for a cheery consensus.

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