Is the Fed a Lifeguard or an Arsonist?
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A poll of CFA Institute readers showed showed which behavioral biases affect the investment decisions of professional investors.
The results are shown in the chart below.
I am not surprised by the results, but a rational investor would put these in reverse order.
Compounding wealth, which should be the primary objective of every investor, depends first and foremost on avoiding large losses. Based on the poll, loss aversion was the lowest ranked bias. Warren Buffett has commented frequently on the importance of limiting losses. His two most important rules are: “Rule #1 of investing is don’t lose money. Rule #2 is never forget rule #1.”
I have written about investor behavioral biases. In 5 Mental Traps Investors are Falling In To Right Now, my partner, Lance Roberts, lucidly pointed out, “Cognitive biases are a curse to portfolio management as they impair our ability to remain emotionally disconnected from our money. As history all too clearly shows, investors always do the “opposite” of what they should when it comes to investing their own money.”
Lance’s quote nicely sums up the chart above. These same biases driving markets higher today also drove irrational conduct in the late 1920s and the late 1990s. Currently, valuations are at or near levels reached during those two historical market peaks. Current valuations have long since surpassed all other prior valuation peaks.
One major difference between the late 1920s, the late 1990s and today is the extent to which the Federal Reserve is fostering current market conditions and imprudent investor behavior. To what extent have investors fallen into the overconfidence trap as the herd marches onward?
This “ignorance is bliss” type of behavior raises some serious questions, especially in light of the recent changes in Fed policy.