Reduce Investment Emotions by Indexing

Physician's Money Digest, February28 2005, Volume 12, Issue 4

The phrase coined by AlanGreenspan to describe the runawaystock market was "irrationalexuberance"—but hehadn't seen anything yet. Although theFederal Reserve Chairman made the commentin December 1996, blue chip stocksproceeded to go up another 100% beforefinally topping out in March 2000.

Investment Challenge

Investors are emotional, and eventhough we'd like to think we are rational,more often than not it is our emotions, notcommon sense, that drives our investmentdecisions. As more physician-investorsaccept the challenge of building a retirementportfolio, they are starting to tune into the concept of index funds as a smartway to deal with the emotions of investing.

When you embrace the simple conceptof indexing (ie, investing in funds thatinvest in the entire stock market or specificdimensions), you don't allow yourself tobecome emotionally attached to an investment.You are freed from the emotionaldecisions of what and when to buy andsell. This is especially true for owners ofactively managed mutual funds.

Bad Track Records

As consumers, we rely heavily on ourpast experiences when making decisions topurchase something. All too often, we takethis approach to investing in mutual funds.The efficiencies of the marketplace exhibita powerful force called "reversion to themean," which implies that what has outperformedin the past tends to underperformin the future, relative to other marketdimensions. Based on this, the logicalchoice would be funds that have lousytrack records, as they are apt to experience"reversion to the mean" in the future.

Unfortunately, our emotions won'tlet us go there. We are not inclined tochoose mutual funds with miserabletrack records, opting instead to buywhat's hot and sell it in frustration whenit's not—our emotions hinder us fromconsidering anything else.

When you embrace the simple conceptof indexing, you have made one of themost important investment decisions ofyour life because you remove yourselffrom the emotional roller coaster of thestock market. This doesn't mean youwon't experience the short-term volatilityinherent in the markets, but it does meanthat, year in and year out, you'll have confidence that you are maximizing yourreturn potential in common stocks.

Bill Schultheis is the author of The

Coffeehouse Investor: How to

Build Wealth, Ignore Wall Street

and Get On With Your Life

(Longstreet Press; 1999). He is also

an investment advisor with Pacific

Asset Management in Kirkland, Wash. He welcomes

questions or comments at 425-820-1769 or

billschultheis@pacificasset.net. For more information,

visit www.coffeehouseinvestor.com.