People love to speculate. Polls have consistently shown that about 50% of American adults report buying a lottery ticket in the previous 12 months. The sports betting industry is growing rapidly, reaching a record $10.92 billion in revenue in 2023, up 44.5% from 2022. So too is the online trading market. Valued at approximately $3.1 billion in 2023, it's expected to grow to more than $4.3 billion by 2028.

Behavioral psychologists have identified a whole host of reasons why humans are prone to engage in speculation. For example, we tend to be overconfident, we like to follow the herd, and we don't want to miss out on lucrative opportunities.

Social media and smartphones have only exacerbated our tendency to speculate. We're constantly seeing others trading and gambling, and it only takes a matter of seconds, and a few clicks or taps, to join in.

Even Isaac Newton Succumbed

The frightening thing about speculation is that even the smartest people are tempted to try it. Take Sir Isaac Newton, for example. Few people, if any, in history have contributed as much as he did to our understanding of mathematics, optics and astronomy. And yet even he was caught out by the notorious South Sea Bubble in 1720.

When the South Sea Company stock price fell from £1,000 to £100, Newton lost an estimated £20,000, which was a very significant sum at the time. "I can calculate the motion of heavenly bodies," he is reported to have said, "but not the madness of people."

What Newton was acknowledging was that the financial markets can be very unpredictable and that they are greatly influenced, at least in the short-to- medium term, by human behavior. There are certain things that even a mind as brilliant as his cannot master.

As Mark Hebner explains in his book Index Funds: A 12-Step Program for Active Investors, whose tenth edition was published in December 2023, speculating on the financial markets is a very bad idea. There have always been speculative frenzies, and probably always will be, and the sensible strategy is not to get involved. Passive investing — buying globally diversified portfolios of passively managed funds and refusing to pay attention to short-term market movements — makes much more sense.

Simple in theory, not so easy in practice

Although a passive buy-and-hold strategy sounds simple in theory, it can be very hard to implement in practice. Why? Because stock market crashes are almost inevitable, and often brutal, and the emotional and psychological impact they have on investors can be very damaging.

The UBS Global Investment Returns Yearbook records the performance of different asset classes all over the world from 1900 onwards. The latest yearbook highlights some of the biggest market drawdowns in that time. In the bear market of 2000-03, for example, the world equity index fell by 44% in real terms. From the start of 2000 until the trough of the bear market in March 2003 the real equity returns were even lower at -47% in the US, -53% in Japan and -65% in Germany.

Four years later, stock markets fell again. The real return on the world index from the market peak at the end of October 2007 to the trough in March 2009 was -58%.

Although markets often recover relatively quickly — the Covid crash in 2020 is an obvious example — markets can be underwater for many years. After the 1929 crash, for instance, U.S. stocks fell to a trough in July 1932 that was 79% below their September 1929 peak in real terms. It took until February 1945 for markets to recover.

Although bond markets are usually far less volatile than equity markets, they too can suddenly fall, as they did in 2022, for instance. Bond bear markets can also last a very long time. According to the UBS yearbook, U.S. bond prices fell by 67% after their peak in December 1940, and, in real terms, the drawdown lasted for more than 50 years!

The emotional toll of market falls

Crashes and bear markets play havoc with our emotions. When prices fall sharply, the brain's amygdala floods our bloodstream with corticosterone, fear kicks in, and we're overwhelmed by the urge to sell. But selling equities, or reducing our exposure, after prices have fallen only turns paper losses into actual losses.

The longer a bear market continues, the more tempting it can be to bail out. Many investors who manage to keep their discipline at the start of a bear market eventually decide they cannot hack it any longer. Sadly, some of them capitulate just before prices start to recover.

Another danger is that we pile into investments after prices have risen, assuming that the upward trend will continue. Again, there's a neurobiological response in our brains. The reflexive nucleus accumbens fires up at the back of the frontal lobe, and we instinctively want to buy. What happens in all too many cases? You've guessed it — investors buy just as prices start to fall.

In other words, timing the market — getting in and out at the right time — is a highly seductive notion. But it's exceedingly hard to execute in practice with any degree of consistency. Even the professionals tend to get it wrong more often than they get it right.

Poor timing decimates returns

Buying high and selling low can have a devastating effect on our portfolios. We are regularly reminded of this by the annual publication by the investment research firm Dalbar Inc. of its Quantitative Analysis of Investor Behavior report, or QAIB.

The charts below are based on data from the latest QAIB report and show the difference in performance as well as the growth of $100,000 between the average equity investor and the S&P 500 Index for the past 30 years (through 2023). Returns for the average investor were about 44 per cent lower than the index return.

So what's the answer? How can you avoid being sucked into the next speculative bubble?

The first thing is to recognize that you are hard-wired to speculate; it's how the human brain has evolved. Remember, as well, to stay humble, and recognize how hard it is to beat the stock market. In the long run, only a tiny fraction of professional fund managers succeed in doing it on a properly cost- and risk-adjusted basis, so do you honestly think that you can do any better?

But the single most important thing you can do is to find a financial advisor who not only uses low-cost index funds but who also understands behavioral finance and how to protect investors from their emotions and behavioral biases.

The chart below shows the findings of an internal analysis of the performance of 533 IFA clients who worked with our advisors for at least eleven years from January 1, 2008, through December 31, 2018. It wasn't easy to be an investor for the first 15 months of that period. Markets had already fallen substantially and continued to do so.

IFA strongly advised all of its clients at the time to stay invested and carry on regardless. 229 clients followed that advice. 161 clients chose not to follow the advice and instead either increased or decreased their risk exposure. The other 163 clients chose to make more modest adjustments.

The clients who followed our advice captured approximately 100 percent of the benchmark index returns per year on average; the clients who didn't captured only about 78 percent of those returns.

These findings serve as a very strong argument for using a financial advisor. As Mark Hebner explains in his book: "Knowledgeable passive advisors help their clients stay invested and rebalance throughout market turbulence. Such behavior enables these investors to maximize their ability to capture returns."

Of course, the volatility we saw in 2008 and 2009 was exceptional. But similar periods of market turbulence have occurred again and again throughout financial history. Who knows? The next market crisis may be just around the corner. So why not complete our survey and check your risk capacity score today?

Stop speculating and start investing. Your future self will thank you.

 

---

ROBIN POWELL is IFA's Creative Director. He always works as a freelance journalist and author, and as Editor of The Evidence-Based Investor.

---

This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal.  For more information about Index Fund Advisors, Inc, please review our brochure at https://www.adviserinfo.sec.gov/ or visit www.ifa.com.