“Animal spirits” shouldn’t have a place in your investments

For those who are contemplating making portfolio changes as a result of this recent rally, ask yourself if you panicked on election night (when the Dow was down 800 points)? Or earlier this year when the market got off to its worse start on record? Or last summer when the Dow opened down 1,000 points?

In other words, the people who now want to chase the market after recent gains, are the same who are first to panic when inevitable volatility hits. This is a result of recency bias, or the temptation to chase gains, even though it hurts much more to lose money than to lose out on making money.

First, let’s put this recent rally into perspective. A 1000 point rally sounds great, but it’s only about 5% when the Dow is at 19,000. It’s important to look at percentage moves, instead of how many points the Dow moves. At 20,000, the daily point swings in the Dow are going to be higher than usual.  Just like the 800 point drop in the Dow on election night sounded worse than it really was (4%), a 1000-1500 point increase sounds much better than it really is. Much of the gains have come from the underperforming sectors of the last few years (Financials, Industrials, and Basic Materials). And as long as we are on the topic, the Dow index itself is flawed and shouldn’t be looked at anyway.

It appears part of the rally is due to an increase in sentiment. Let’s not forget that sentiment was favorable when George Bush, Jr. took office. His MBA and understanding of business was supposed to be very supportive for stocks. The result was one of the worst 8 year periods for stocks in recent history. This isn’t a fair comparison because this time period includes 9/11, a catastrophe no one could ever have predicted, along with two economic recessions. But fast forward to 2008 and the consensus was that Barack Obama was going to be awful for the stock market. The result was one of the biggest bull markets on record.

This is not to draw any conclusions. I’m simply pointing out that sentiment doesn’t always equate to actual performance. Because of one month’s performance, conservative investors now want to become more aggressive. We know that stocks don’t go up forever, and they don’t go down forever either. We’ve been saying for years that things aren’t as bad as they are being described. And as the Dow inevitably trades above the 20,000 level, sentiment may eventually swing too far in the opposite direction.

The reality is that the market has more than tripled over the last seven years. Even though the market is likely to move higher, it’s hard to envision similar performance over the next seven years. In fact I think it’s safe to say it’s more likely we experience a bear market (recession) before the market triples again.

It’s usually best to maintain a balanced approach to investing. Not getting too carried away when things look bad (stocks go on sale) and when things look good (higher valuations, lower dividends, lower expected returns). Focus on those things that you can control, such as keeping costs low and maintaining an asset allocation strategy that suits your risk tolerance and time horizon. And don’t scrap a perfectly good aset allocation just because it underperformed for one month. Animal spirits have no place in your investment accounts!

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