Just more than a week ago, the NFC’s New York Giants defeated the AFC’s New England Patriots in the 46^th edition of the Super Bowl and that should have all investors cheering, even those from Boston.  That’s because according to the Super Bowl Indicator, a win by a team from the old NFL (now the NFC) portends a positive year in the stock markets while a win by a team from the old AFL (now the AFC) foreshadows a fall. 

Sound crazy?  Well, it has been right more than 80% of the time, including each of the last three years and has a higher accuracy than many market prognosticators.  There are many other statistical indicators that investors follow too:  the January Effect , “Sell in May and go away” , Santa Claus Rally , presidential term cycles  and the hemline indicator  to name a few. 

Why do investors gravitate to these types of indicators to give them direction for the coming year?  Behavioral finance uses terms like “Representativeness Heuristics” and “Clustering Illusions,” but what they are getting at is that the human mind is a pattern-seeking device, preferring order over randomness.  While this helps the brain organize and quickly process large amounts of data, it is a mental shortcut that can be detrimental in investing.  We allow ourselves to get correlation confused with causation.  Any back-tested investment strategy which has mined data  to find a pattern runs the same risk. 

Which leads me to another thought on why investors do it: it’s easy.  It’s a lot easier to invest based on some technical or statistical indicator than it is to have a disciplined investment strategy, doing hard and time consuming work of understanding companies and their financials and assessing their attractiveness relative to current stock price.  It’s a lot easier to have confidence in a strategy you know has worked in the past even though there is no reasonable rationale it will continue to work in the future.

Returning to the Super Bowl Indicator, it is interesting to note that when it was first proposed  back in 1978, it had a 100% success rate (11 out of 11).  By 1998, the success rate was still greater than 90% and now had 30 years of history to tout its predictive power.  Since then, the success rate has been barely above 50%, missing 1998 and 1999’s spectacular rally (Broncos win) and taking the brunt of the 2008 bear market (Giants win).  Even other indicators with some underlying justification like the January Effect have lost some of their luster over the last 15 years.

All that being said, I’m feeling pretty bullish for 2012: Who needs to worry about Europe’s financial crisis, the US debt and deficit, and Middle East stability when it was one of the best January’s ever, it’s the fourth year of a presidential term, and the Giants won the Super Bowl.

I noticed that the closing price of the S&P 500 index last Friday (Feb. 10, 2012) was essentially the same as it was a year ago, 1342.64 compared to 1329.15.    (Actually it is up about 1% based on price and has returned about 3.7% when including dividends.)   Of course, anyone who follows the markets knows that it hasn’t been as calm as the one-year performance summary would indicate.  From the starting point on Feb. 11, 2011, the index was zig-zagging along within a fairly narrow range until July 22 when it started its downward spinout as the deadline for a U.S. credit default loomed and lawmakers were at an impasse over raising the debt ceiling.

One-Year S&P 500 Performance:  Feb. 11, 2011 to Feb. 10, 2012

And there were plenty of other issues keeping investors nervous, such as fears of the U.S. going back into recession and worries about which European countries might default or even drop out of the euro zone.   And when investors get nervous, they pull the trigger the quickest on the most economically cyclical sectors of the country.   From our Feb. 11, 2011 starting point until the year’s low on October 3, four sectors had lost over 20% of their value and the financial sector was down a whopping 34%.   The graph below shows the performance of the nine S&P 500 sectors, with blue bars indicating the full 12 months, red bars indicating the period from Feb. 11 to October 3, 2011, and green bars indicating the recent period from Oct. 3 through Feb. 10, 2012.   The huge swings in performance of the energy, industrials, materials, and financial sectors ably capture the shifts in investor sentiment.

The turn in sentiment undoubtedly reflects a number of signs that the U.S. economy is strengthening and perhaps a sense that Europe will keep muddling through and will avoid a major financial crisis.   Perhaps the fact that bond yields are so low is also prompting certain investors to shift some funds over to equities, thus contributing to their gains.  We believe the 22% rise in the S&P 500 since last October was well warranted given the improving conditions on several fronts, along with very strong U.S. corporate profits.  And we continue to believe that equity prices (both domestic and global) offer good value for long-term investors, although we all know that prices don’t go straight up indefinitely.  Our general advice for people just starting to invest in equities is to do so gradually, an approach called dollar-cost averaging.  This means that you are buying equities at varying prices over a period of time, adding more shares at lower prices and fewer shares at higher prices.

For those wanting to see the actual percentage swings in the sectors over the periods discussed, see the table below.

Recently, I allowed my four-year old son, Ryan, to play a free educational game I downloaded onto my new iPad.  After he breezed through the first three levels, he was greeted by an unfriendly message saying that if he wanted to continue, he would have to pay $1.99 for the full app.  “No way!” I bellowed.  “What a rip off…even if not exactly the same, there has to be a free version of this out there somewhere,” I muttered to myself as I spent the next 15 minutes trying to find one.   When I didn’t, I told him to find another game to play. 

A day or two later, I read a blog Dan Ariely, a professor of behavioral economics at Duke University,  that illuminated me on my own little irrationality.  Behavioral economists call it “anchoring.”  I had become used to the idea that apps were free, so the thought of paying a whopping $2 seemed ludicrous.  Yet just the week before, I spent $6 on a box of popcorn at the movie theatre (which we didn’t even finish, but I had to get because it was the “best value”).  Or what if I put that 15 minutes in terms of the value of my time (say at my hourly planning fee rate) versus the $2 savings?  Or better yet, if I had thought of either the ongoing entertainment or education value that Ryan would have received. 

While this is just one example of a less than rational economic decision, the same irrationality applies to investing.  In an initial planning conference, when I ask a couple what their home is worth, often the answer begins with “well I paid X for it…”  Or better yet, when I ask about what they think a particular stock in their portfolio is worth, the response begins with “I bought it at Y…”  The fact of the matter is: a potential buyer for your home doesn’t care what you paid for it; your cost basis in a stock has no bearing on the underlying value of that business. 

Latching on to a piece of information even though it may have no logical relevance can lead to poor investment decisions.  “If I can only get back to break-even on this stock, then I will sell it.” Or on the flip side, “if I liked it at $50, I have to love it at $30, let’s buy more.”  In either case, there may be a very good reason the company’s stock is trading lower and that money could be better invested elsewhere.  Anchoring can also be displayed more broadly – latching on to the high watermark of your portfolio or beliefs about certain segments of the market, like tech stocks or emerging market stocks.   

Unfortunately, we see time and time again that people do not always make rational financial decisions (or as one colleague titled his book “Why Smart People Do Stupid Things with Money”).  At best, they are just insignificant little quirks.  At their worst however, these decisions can be detrimental to one’s financial well-being.

We may never be able to rid ourselves of this predictably irrational thinking as it may be hard-wired into who we are as human beings.  However, we may be able to overcome it – if we are able to recognize when our mind is trying to play tricks on us and choose to respond differently.

I went home and bought that app.  And Ryan still loves playing it.

For more information:

Beware of the Dreaded Anchoring Bias 

How to Control Your Fears in a Fearsome Market

The Evil of Irrelevant Information