If investors are rational decision makers, then emotion driven bubbles should not be possible. Yet human weaknesses can limit our ability to think clearly.
Many studies of investor behavior have shown that investors are too willing to extrapolate recent trends far into the future, too confident in their abilities and too quick (or not quick enough) to react to new information. These tendencies often lead investors to make decisions that run counter to their own best interests.
The idea that investor psychology can result in poor investment decisions is a key insight of an increasingly influential field of study called behavioural finance. Behavioural finance theorists blend finance and psychology to identify deep seated human traits that get in the way of investment success. Its findings can help you identify and correct behaviors that cost you money.
What commonplace mistakes should investors avoid? Here are Four Investment Mistakes to avoid.
Do not Read Too Much Into the Recent Past
When faced with lots of information, most people come up with easy rules of thumb to help them cope. While useful in some situations, these shortcuts can lead to biases that cause investors to make bad decisions.
One example is extrapolation bias, the over reliance on the past to assess the future. Instead of doing all the necessary and possibly tedious homework in researching a potential investment, investors instead anchor their expectations for the future in the recent past.
The problem, of course, is that yesterday does not always tell you what tomorrow will bring. That is worth keeping in mind if you are drawn to the strong performers of recent years, whether it is emerging markets or precious metals.
The recent volatility in those areas is a reminder that the past is no guarantee of future performance. As Wall Street Journal columnist Jason Zweig said, “Whatever feels the best to buy today is likely to be the thing you will regret owning tomorrow.”
Morningstar’s investor returns show this phenomenon at work. Investors tend to pour money into funds after they have performed well and rushed for the exits after they underperform, resulting in much lower returns (or even losses) for average investors compared with funds’ reported returns.
Realise That You Do Not Know as Much as You Think
In a 1981 study asking Swedish drivers to assess their own driving abilities, 90% rated themselves as above average. Statistically speaking, that is just not possible.
Most of us are just like the Swedes: We think we are more capable and smarter than we really are. As an investor, you should check your excessive optimism at the door. My experience is that when things go well we believe it is all because of how clever we are, and when things go bad, it is just unlucky.
According to several studies, over confident investors trade more rapidly because they think they know more than the person on the other side of the trade. All that trading can be “hazardous to your wealth,” as University of California, Berkeley professors Brad Barber and Terrance Odean put it in their 2000 study of investor trading behavior.
The study looked at about 66,000 households using a discount broker between 1991 and 1996 and found that individuals who trade frequently (with monthly turnover above 8.8%) earned a net annualised return of 11.4% over that time while inactive accounts netted 18.5%.
Investors who traded most often paid the most in brokerage commissions, taking a huge bite out of returns. All that trading might have been worthwhile if investors replaced the stocks they sold with something better.
Interestingly, the study found that excluding trading costs, newly acquired stocks actually slightly underperformed the stocks that were sold. That means that rapid traders’ returns suffered whether or not fees were taken into account.
Some researchers have come to a similar conclusion studying fund manager trading, that is, standing pat is often the best strategy.
If you constantly check your portfolio, you may be tempted to take action at the slightest hiccups in your holdings or in the market.
Limit the number of times you even look at your portfolio; a checkup once or twice a year will be plenty for most investors. That will help you stay disciplined and save you money on transaction fees.
Keep Your Winners Longer and Dump Your Losers Sooner
Investors in Odean and Barber’s study were much more likely to sell winners than losers. That is exactly what behavioral finance theorists would predict. They have noticed that investors would rather accept smaller but certain gains than take their chances to make more money.
On the flip side, investors are reluctant to admit defeat and sell stocks that are underwater in hopes of a rebound. As a result, investors tend to sell their winners too early and hang on to their losers for too long.
That is why it pays to have clear reasons in mind for your purchase of any investment right from the get-go. If your expectations do not pan out, then it is time to sell.
Crafting an investment policy statement that lays out basic parameters for your portfolio and what you are looking for in individual securities is a key way to instill discipline in your financial decision making process.
Periodically rebalancing, but not too often, is another way that investors can avoid mental mistakes when buying and selling. Rebalancing involves regularly trimming winners in favour of laggards. That is a prudent investing strategy because it keeps a portfolio diversified and reduces risk. It ensures that you periodically harvest your profitable holdings but rebalancing too frequently could limit your upside.
Instead, rebalance only when your portfolio is out of whack with your target allocations. Minor divergences from your targets are not a big deal but when your current allocations grow to more than five or 10 percent- age points beyond your original plan, it is time to cut back.
One other key mental mistake is focusing on individual securities in isolation rather than looking at your portfolio as a whole. If you are adequately diversified overall, your portfolio will not exhibit big swings on a day-to-day basis.
But individual holdings can and will gyrate around quite a bit and that could lead you to focus a disproportionate amount of time and energy on certain positions at the expense of the big picture.
It Is All About Discipline
Fortunately, you do not have to be a genius to be a successful investor. As Berkshire Hathaway chief and investor extraordinaire Warren Buffett said in a 1999 interview with Business Week, “Success in investing does not correlate with IQ once you are above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”
It is true that not everyone is gifted with Buffett’s calm, cool demeanor but challenging yourself to avoid your own worst instincts will help you reach your financial goals.
I would like to hear about your thoughts, when it comes to investing.
Oh by the way here are my
Top 5 Books on Investment
#5 Think and Grow Rich” (1937) by Napoleon Hill
“Think And Grow Rich” was written by Napoleon Hill during the Great Depression, and has since sold more than 30 million copies worldwide. Hill conducted extensive research based on his associations with wealthy individuals during his lifetime. At the suggestion of Andrew Carnegie, Hill published 13 principles for success and personal achievement from his observations and research. These include desire, faith, specialized knowledge, organized planning, persistence and the “sixth sense.” Hill also believed in brainstorming with like-minded people, whose efforts can create synergistic energy.
#4 The Intelligent Investor” (1949) by Benjamin Graham
This book was written in 1949 and has been hailed by Warren Buffett as the best investing book ever written. Benjamin Graham is considered the “father of value investing,” a paradigm that advocates the purchase of stocks that appear underpriced relative to their inherent value, which is determined through fundamental analysis. A bit heavy going but worth the effort.
#3 Beating the Street” (1994) by Peter Lynch
Peter Lynch is one of the most successful stock market investors and hedge fundmanagers of the 20th century. He started out as an intern at Fidelity Investments in the mid 1960s. Nearly 11 years later, he was tasked to manage the Magellan Fund, which at the time had close to $18 million in assets. By 1990, the fund had grown to a whopping $18 billion in assets with nearly 1,000 stock positions. During this time, the fund boasted average returns of more than 29% per year.
#2 The Essays of Warren Buffett: Lessons For Corporate America” (1997) by Warren Buffett
In his essays, Warren Buffett – widely considered to be modern history’s most successful investor – provides his views on a variety of topics important to corporate America and shareholders. Young investors can get a glimpse of the interface between a company’s management and its shareholders, as well as the thought processes involved in enhancing a company’s enterprise value.
#1 Rich Dad, Poor Dad” (2000) by Robert Kiyosaki
This classic is a must-read for young investors. Kiyosaki’s view is that the poor and middle class work for money, but the rich work to learn. He stresses the importance of financial literacy, and presents financial independence as the ultimate goal and a way to avoid the rat race of corporate America. The author points out that while accounting is important to learn, it can also be misleading. Banks label a house as an asset for the individual, but because of the required payments to keep it, it can really be a liability in terms of cash flow. Real assets add cash flow to your wallet.