Bulls, bears and ostriches. Which investor type are you?
The ostrich effect may not be a great strategy but, used wisely, it can save you a lot of financial pain.
Why do I check Berkshire Hathaway's share price every day when I don't intend to sell the stock for decades? The answer, as you might suspect, lies in human psychology – the stock has done well for me and I like its long-term prospects, so checking up on it adds a few moments of pleasure to my day.
Psychologists call this ‘selective attention' and it works both ways. Chances are, you didn't leap at the opportunity to open your last letter from the tax office, and you probably put off checking your credit card balance until after your holiday.
People have ‘asymmetric preferences for the timing of resolution of uncertainty', according to researchers at Carnegie Mellon University. In other words, we seek out information more actively if we suspect good news and stick our heads in the sand given preliminary bad news.
Traditionally, the stock market is viewed as a collection of bulls and bears – those buying stocks in the hope of future profits, and those who are selling to them, hoping to avoid losses. But the Carnegie Mellon research suggests a new class of investor – the ostriches.
The study, using data from fund manager Vanguard, found that when the overall stock market is up, investors gleefully check how their stocks are doing. But when the market is down, investors check the value of their portfolio less often – something the researchers call ‘the ostrich effect'.
The scientists concluded that we avoid financial information that may make us feel bad by pretending it doesn't exist – and this is especially so if we feel the new information could jeopardise our feeling of competence. After all, suspecting something bad may have happened isn't nearly as upsetting as knowing for sure that something bad did happen. If you don't check your portfolio, you can fantasise about how well it might be beating the market.
The ostrich effect explains another market observation – during major market downturns, such as the global financial crisis of 2008-9, trading volumes decline and liquidity dries up. This is consistent with investors ignoring their portfolios during times of trouble and not wanting to lock in losses. In bull markets, more investors are following the market, which increases trading volumes.
Not all bad news
If you're swimming at the beach and uncertain about a large grey fin moving towards you, avoiding new information probably isn't a winning strategy. But having a bird brain during market downturns might actually work in your favour.
A University of California study of 66,000 investors found that the higher a portfolio's turnover, the lower the average return. Those who traded the most lagged the overall market's performance by 6.5%. As the researchers put it, ‘trading is hazardous to your wealth' because it adds ‘frictional costs' – like brokerage fees and taxes – which quickly bite into your return (see Why the dead outperform the living).
While the ostrich effect may reduce excessive trading, avoiding information completely probably won't get you very far. You need to find the right balance. Here are a few tips:
1. Select wisely: Having selective attention isn't the enemy – the problem is when you only filter out bad news. Instead, aim to filter for the quality of information. Avoid media commentary that uses hyped language or emphasises a stock's price movement – rather than the company's financial and competitive position – because this type of news is designed to excite rather than educate.
2. Focus on long-term fundamentals: Whether your portfolio went up or down 3% today probably doesn't matter if you're investing for the next 10–20 years. What does matter is whether your stocks have sustainable competitive advantages, strong balance sheets, and whether they trade at a discount to intrinsic value.
3. Recognise that panics are often the best time to buy: If you feel yourself avoiding your portfolio during a downturn, remind yourself of what happened to the stock market after history's biggest downturns, like 2009, 2001, 1987, 1929 etc. As Warren Buffett says, ‘Be fearful when others are greedy and greedy when others are fearful'. If you stick to buying high-quality companies when they're undervalued, you'll do well – and your desire to act like an ostrich is probably a sign that the market hasn't been that cheap in a while.
Want access to our latest research and new buy ideas?
Start a free 15 day trial and gain access to our research, recommendations and market-beating model portfolios.Sign up for free
Join the Conversation...
There are comments posted so far.