The Scorpion and the Frog

The synopsis of The Scorpion and the Frog fable is as follows:

A scorpion asks a frog to carry him over a river. The frog is afraid of being stung during the trip, but the scorpion argues that if it stung the frog, the frog would sink and the scorpion would drown. The frog agrees and begins carrying the scorpion, but midway across the river the scorpion does indeed sting the frog, dooming them both. When asked why, the scorpion points out that this is its nature.

The lesson of this fable is that certain behaviors are inevitable, even if they are not logical. Some behavior is simply in one’s nature.

The average individual investor goes through cycles of buying high (greed) and selling low (fear) as the market fluctuates until they either run out of money or shun the market altogether.

Why does this irrational behavior happen? I would suggest (as noted in the fable) part of it is human nature, a cycle between greed as the market rises and fear as the market declines. This graphic illustrates one’s emotions as the market fluctuates:

As a result of these emotions, investors tend to buy stocks when they are greedy and sell stocks when they are panicked or fearful (when it would be most advantageous to do the opposite). This is where a financial advisor can really add value – when an individual’s human nature would otherwise cause him/her to deviate from a long-term plan.

The ironic part to all this is that it is easily recognizable. If explained to (almost) anyone, it would be easily understood. However, investors still make poor choices despite knowledge to the contrary. Just like the scorpion who knew that if it stung the frog, the frog would sink and the scorpion would drown and yet it did so anyways, investors still make poor decisions because some behavior is in one’s nature.

Terrance Odean, Rudd Family Foundation Professor of Finance at the Haas School of Business at the University of California, Berkeley, notes the following:

Someone once said to me, “We can’t control our initial reactions, but we can learn to control what we do next.” Investors will always have cognitive biases. One approach to overcoming them is to practice recognizing biases when they manifest themselves and then adjusting our behavior.

An advisor can ensure an investor stays true to a dollar-cost averaging strategy and an appropriate asset allocation strategy through rebalancing, two essentials to avoiding this greed-fear cycle.

-Joe

 Sources:

http://en.wikipedia.org/wiki/The_Scorpion_and_the_Frog
http://rpseawright.wordpress.com/2014/04/16/five-good-questions-with-terry-odean/