What do beer and investing have in common? Besides, of course, the fact that when the markets are turbulent, you’re more likely to reach for a beer?
Both exemplify a tendency called the bullwhip effect. First demonstrated in the 1960s by researchers at MIT, groups of students would act as a supply chain for a beer company, but only one group would actually see customer demand. The remainder of the teams would see the other suppliers and attempt to react to what the other suppliers were doing. Because of the lack of information and communication, minor changes in demand would cause enormous oscillations in supply. Graphed out, these oscillations looked a lot like a bullwhip does when it’s cracked, with each oscillation getting larger over time.
Investors can also be subjected to the bullwhip effect, just as they often exhibit herd behavior. Money flows into the market after peaks and as the market is on the way down, and it flows out of the market after troughs and as the market is on the way up. The bigger the magnitude of the move, the more money flows into and out of the market.
Focusing in on individual behavior, this effect can be dangerous. The closer one is to retirement, the more an investor will be tempted to try to hit a home run to make up for a loss, taking on more risk in the face of a perceived income deficit. A similar outcome holds true for the opposite end of the spectrum. If you’re younger and just had a great year, there’s a temptation to lock in a win and take some of the money off of the table. The desire not to lose money, particularly once you've gained in your investments, is based on prospect theory, which states that the joys of winning aren't as great as the pains of losing a similar amount. You’ll gamble more to make up for a loss but will book a small win just to say that you've won.
How can we prevent the bullwhip from whipping our portfolios? The key is to automate as many of the decisions as possible to keep us from outthinking ourselves. The fewer decisions we have to make, the less subject to ego depletion we are, and the less likely we are to make mistakes in a heated rush.
- Value-cost averaging. If you’re consistently buying or selling on a regular schedule based on what the market has done and your target allocation, then you’ll not be tempted to deviate, as your plan accounts for highs and lows in the market.
- Set an appropriate asset allocation target. If you’re behind on your retirement plan, then it’s going to be tempting to take inappropriate risk. Instead, stick to your asset allocation targets so that you don’t try to swing for the fences, miss, and make your situation worse.
- Pay down debts. If you’re in debt, then you’re going to be tempted to try to take more risks because you incorporate debt payments into the income you’ll need in the future. Get aggressive about paying off your debts, as that’s a known rate of return and won’t fluctuate with the markets. It’ll also free up more money for saving and investing when you’re debt-free.
- Ramp up savings. Are you at least investing enough to get a match in your 401(k)? Have you maxed out your individual retirement account, or any other tax-free or tax-deferred investing options? Can you find a little room in the budget somewhere? Squeeze a little more out of your budget; after a couple of months, you’ll stop noticing that you miss whatever it is that you gave up to save more.
If you can automate your investing as much as possible, you’ll find the temptation to react when the market has its random swings much less powerful than it would be if you were trying to time the market and checking your portfolio balance every three minutes. Instead, sit back, relax, and have a beer. It will drive the hops producers crazy.
Jason Hull is a candidate for the CFP(R) Board's certification, is a Series 65 securities license holder, and owns Hull Financial Planning.