The Human Mind is a wonderful thing. It has built in mechanisms which allow us to cope with life as it unfolds. One of these mechanisms is our ability to categorize things. This ability to categorize is essential to our well being. For example, a tiger is nothing more than a big kitty, yet the tiger could easily eat us. Being able to quickly categorize the similarities and differences of these two kitties is essential to our longevity.
We can all agree the current times which have set about us are uncomfortable, and even downright scary. There is a fear in the air about us, be it at the water fountain in whispering groups or late at night alone with our thoughts. However, it is often times such as we are experiencing now, these trying times of hardship and adversity, when Homo sapiens are "forced" to shine. Change is in the air.
We have been sending a warning out to all of you about bond's and bond mutual funds. Obviously no one is paying attention at least according to the latest statistics from the Investment Company Institute. Their latest report on mutual fund flows for the week ending May 20, 2008 indicated that $8.4 Billion of new investments were made in Bond Mutual Funds, while only $252 million was invested in Domestic Stock Mutual Funds. I don't get it!
You may have noticed in the past, both on this show or speaking directly with Kendall and me, that we tend to be a bit harsh on economists. Perhaps we should be a bit more forgiving of them because we too know how hard it is to throw your thoughts and predictions out to the world for open scrutiny. However, often times our common sense approach conflicts with what we view as the trend economists often take towards getting stuck in their data, and then filtering that data through a "glass half empty" medium of explanation.
In 2005 Andrea Frazzini and Owen Lamont from Yale University published a preliminary research paper simply titled "Dumb money: Mutual fund flows and the cross-section of stock returns". This was their conclusion:
"In this paper, we have shown that individual investors have a striking ability to do the wrong thing. They send their money to mutual funds which own stocks that do poorly over the subsequent years. Individual investors are dumb money, and one can use their mutual fund reallocation decisions to predict future stock returns."
Last week, in anticipation of a positive outlook resulting from the Treasury's Stress Test on the country's largest financial institutions, and the surprise employment figures that indicated a slowing in number of people losing their jobs, the markets soared with the Dow Jones ending up over 4.4% for the week. Although these may be market moving events, it was our own Jeffrey Lacker, Fifth District Federal Reserve President who caught my attention.
"Bulls make money, Bears make money, but Pigs get slaughtered".
Most professional investors and investment advisors are familiar with Kahneman and Tversky's Prospect Theory, developed in 1979 as an alternative to the Expected Utility Theory. The hope was to understand a psychologically realistic way that we humans make our financial decisions. You may have never heard of this theory, however, you, the individual and those of us who are professional investors are the actors that this theory is trying to recognize.
Why is it that we feel OK when we sell something at a profit and absolutely miserable when we sell any stock, bond or for that matter, real estate at a loss? Why is it we don't have the same problem when we sell a gift or an inheritance at less than what the donor paid? Each of us have our own reason for this, but in most cases, reacting to your emotions will ultimately have the wrong outcome - reduced returns and less income to spend.
Every three months publicly owned corporations release a series of financial statements to their shareholders. These reports are packed full of information that it seems only the top management of the company, analysts who make earnings estimates and a few of us in the investment management business actually read.
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