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Avoid the folly of rear-window investing

Financial planner Carl Richards calls it the behavior gap — the tendency of investors to earn returns below that of the very investment vehicles in which they invest.

This feat is accomplished by a strategy that is the equivalent of driving forward but observing the rear-view mirror. That leads to investors buying yesterday’s winners (at high prices) and selling yesterday’s losers (at low prices). Unfortunately, you cannot buy yesterday’s returns, only tomorrow’s.

The latest example of investors behaving badly could appropriately be labeled as “fool’s gold.” At its peak in early September 2011, the price of gold hit around $1,900 an ounce. As I write this, the price had fallen to about $1,230. Since the key to successful investing is to buy stocks (or any asset) like we buy socks — when prices are low — you would think investors who were buying gold at $1,900 should certainly welcome the opportunity to buy at $1,230 — if you liked it at $1,900, you should love it at $1,230!  Have they been doing so?

We can see evidence of investor behavior by looking at what has happened to the assets under management in the SPDR Gold Trust Shares ETF (GLD). Last August, the net assets in GLD totaled $78 billion. Net assets are now down to about $32 billion, a fall of almost 60 percent. Yet the Net Asset Value (NAV) of GLD is only down from about $184 to about $119, a drop of 35 percent. Based on only the change in the NAV, assets under management would have been about $50 billion. The love affair with gold drove investors to buy more and more gold at higher and higher prices. And if gold continues to fall, it seems likely that investors will sell at lower and lower prices, chasing yesterday’s returns.

While I’m not a particular fan of owning gold -- if you’re going to invest in commodities at all, I prefer an investment in a broad based commodity index such as the S&P GSCI -- if you do so it should be part of your asset allocation plan. In other words, you set a target allocation, say 5 percent, and rebalance your portfolio as required to maintain that level. You might set a rebalancing band of a relative 25 percent of the allocation. That would produce a maximum allocation of 6.25 percent and a minimum allocation of 3.75 percent.

If the market drove your allocation beyond those boundaries, you rebalance. Doing that allows you to do the opposite of what most investor’s instincts (and stomachs) lead them to do. Rebalancing requires you to sell what has done relatively well (at relatively high prices) and buy what has done relatively poorly (at relatively low prices). That’s a lot better strategy than buying high and selling low.

In one of my favorite Seinfeld episodes, George Constanza has an epiphany that all of his instincts have been wrong, and that he would be best served by doing the opposite. It seems that many, if not most, investors would benefit from the same epiphany. 

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