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Even Smart People Make Mistakes

Even smart people make mistakes. What differentiates them from fools is that once they have learned their behavior was a mistake, they don't repeat it. Consider the following.

John worked with his investment advisors to develop an investment plan in 2005, including an asset allocation and rebalancing table. Their equity allocation decision included a careful analysis of John's ability, willingness and need to take risk. They reviewed the historical evidence including the bear markets of 2000-2002 and 1973-74 (both of which saw losses of about 50 percent) and also the far greater losses experienced during the Great Depression.

As a tenured professor at a major university, John's income was stable and uncorrelated to the risks of equity investing. Given that he was only 40, his horizon was long. John wanted to accumulate significant wealth to fund his retirement, creating a high need to take risk. Finally, John told his advisor that he was aware of the risks of equity investing, but had a strong stomach and was willing to take risk. After a long discussion, John decided on an 80 percent equity allocation.

Unfortunately, the bear market of 2008 taught John that he was overconfident of his ability to stand the emotional stress of a severe bear. While his advisor helped him avoid panicked selling, John not only was unable to rebalance (buy equities to restore his portfolio's allocation to its targets), but he was so nervous he lost sleep and could not enjoy his life. (And he drove his wife crazy.)

With the rally since March, John had recovered a significant part of his losses and was feeling much better. However, he was tempted to make the gamblers mistake of trying to get back to even before altering his investment plan. The advisor convinced him this was an error, as John had already made the mistake of overconfidence, causing him to take more risk than he could handle. Repeating that error would be what Albert Einstein is said to have called insanity -- doing the same thing and expecting a different outcome.

Correcting the Problem
The advisor went on to explain the right strategy would be to lower his equity allocation to a level more appropriate to his newly discovered risk tolerance and adapt the rest of his plan to the new reality. John would have to either lower his goals to be more in line with the expected returns from a portfolio with a lower equity allocation, save more or plan on working longer.

The advisor explained that it was important for John to recognize that whatever the "cost" of his mistake, it was a sunk cost and, thus, irrelevant to making the right decision now.

As the events of 2008 demonstrated, bear markets have the nasty habit of turning investors with 30-year horizons into investors with 30-day horizons. Bottom line: If you learned you were overconfident of your ability to deal with bear markets, admit your error and lower your equity allocation.