Friday, October 9, 2009

Greed (Oct. 9, 2007) and fear (March 9, 2009)

Today marks precisely 2 years since the Dow Jones Industrials Average (DJIA) reached its all time high of 14,164.  Investors at that time were focused on profits to be made in stocks after seeing over 115% of stock market return since the lows of 2002.  It would be fair to say greed ruled the day at that point.

Fast forward to March 9, 2009 when the DJIA closed at 6,547 as regulators and investors alike worred about a severe recession and the deflationary effects of a near collapse of the financial system worldwide. It would be fair to say fear ruled the day at that point.

For comparison purposes the DJIA closed today (October 9, 2009) at 9,864.

Behavioral finance studies tell us the average investor is much more willing to buy when the market has been going up, even if this results in overpaying for an asset and reducing future returns.  Likewise, the average investor is much more willing to sell when the market has been going down, even if this results in missing out on future recovery and reducing returns.  A study by Dalbar, Inc. shows that for the 20 years ended December 31, 2008 the average investor (with their buying and selling at the wrong time) earned only 1.9% per year while the S&P 500 averaged 8.4% for the same time period.

There is much to learn from examining this market history.  Hopefully the lesson of not allowing greed and fear to overwhelm rational decision making will be remembered by investors the next time markets reach a high or low extreme.