Emotional decisions can have disastrous results

By DAVID MOON, Moon Capital Management, LLC
December 5, 2010

Do you know what is more dangerous than a hungry, wild raccoon on your back porch? A hungry, wild mother raccoon, cornered on your back porch, with rabies and nowhere to go, stranded while out looking for food for her offspring.

When a wild animal is scared or threatened, it can do some dangerous, unpredictable things, especially when trying to protect itself or its family.

People are the same way, including the way they handle their investments.

While people don’t usually run the same risk as a raccoon of getting shot by a homeowner, their primal, emotional decisions can similarly have disastrous results.

Retired folks, like my father-in-law, used to depend on interest from CDs and money market funds for most, or all, of their income. It wasn’t that long ago that it was pretty easy to earn five percent or more on a simple, almost risk-free fixed-income instrument.

According to the FDIC, the national average one-year CD rate is now 0.54 percent. The average money market fund pays less than half of that. The Federal Reserve Board’s efforts to stimulate the economy may be doing wonders for borrowers and investment banks, but it has wreaked havoc on savers.

This tempts individual investors to put their money into terribly inappropriate investments.

One place that typically sees a rush of new money in times of tumult is the annuity market. I see all sorts of promises to pay exorbitant rates of interest for certain periods of time, but there is always a catch. If nothing else, both the rate and the principal amount of your investment is usually backed by a single company – an insurance company. While that may sound safe, remember that one of the largest and presumably safest insurance companies in the world – AIG – went from being a AAA company to practically insolvent in a matter of months.

When people get desperate, they tend to make riskier decisions. They put money in the stock market that they will need within a year or so. Not wise.

They lengthen the maturity of their bond portfolio – either unknowingly, by buying high-yielding bond funds without checking the maturities of the bonds in the fund, or recklessly, simply by ignoring the risks of potential inflation on the prices of long-term bonds.

When investment promoters begin to package multiple investments into a single product, watch out. These are usually specifically designed for angst-ridden investors, often those specifically seeking higher fixed yields. These structured products are usually difficult for investors to understand and often include much higher fees than if the component investments were purchased separately.

A study by the Securities Industry and Financial Markets Association found that small investors were likely to have more than three times the amount of structured products in their portfolio as someone with a $5 million or larger portfolio. The conclusion was that more sophisticated investors are less likely to fall prey to the emotional sales pitches used to lure investors to these things.

Emotional sales pitches made to emotional investors...a dangerous combination.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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