Investors: Ignore Your Instincts

(MoneyWatch)  We all use guidelines to make our way through life. They serve us well most of the time, but can serve our heads on a platter when it comes to investing. Let's delve deeper into three of these rules of thumb that have hardened into head-serving myth for many investors.


Myth #1: Follow your instincts

How many times in our lives have we said, "I knew this didn't seem right?" I know there have been countless times where an outcome caused me to regret that I didn't listen to that inner voice. My instincts have typically proven to be a good thing, whether being presented with a deal that seemed too good to be true, or whether there was something about an individual that I just didn't trust.

As is always the case with "Monday morning quarterbacking," most investors can look back at the stock market last summer and say they knew the credit crisis was predictable and the crash was inevitable. It was the only possible outcome to Wall Street lending money to millions of people with the net worth of your average paper boy and nary a prayer of paying it back.

Unfortunately, during the height of the easy credit bull market, investors weren't employing that logic, but rather were investing based on their instincts at the time. And their instincts at that time were telling them that real estate not only wouldn't go down in price, but couldn't. Hence money continued to pour into the market in 2007. Now that the crash is here, hindsight tells us something quite different.

Hindsight tells me that if I invested according to how my instincts made me feel, I'd have a standing reservation at the poor house. During a bull market, greed has me wishing I had a greater proportion of my portfolio in stocks and I feel like increasing it. In a bear market like last March, my stomach sinks with every dollar my portfolio goes down and I feel fear and want to sell. Of course the market gurus and the media only compound the problem by pandering to these feelings.

Listening to those talking heads, or my own knee-jerk feelings, would have me buying after the market has gone up and selling after it has dropped. I'd have an E ticket on that roller coaster ride of buying a hot stock or mutual fund after it had skyrocketed and selling it when it started circling the drain. Wheee! Unfortunately, that's just what most investors do, and how they end up in buy high/sell low land.

Since it's pretty close to impossible to turn off an emotion in only one aspect of your life, I recommend investing exactly the opposite of how you feel. Instead, pick an overall stock, bond, and cash allocation, rebalancing periodically. Yes, I know it's a bitter pill to swallow, but rebalancing means selling some of your stocks after the market has gone up, and buying some after the market has dropped. Wrong as it feels to say goodbye to a winner and hello to a loser, boy does it work.

Stay tuned, and on Wednesday, I'll show you why being proactive with your portfolio sounds rational but doesn't work either.