By “you” I’m really referring to “we.”
James O’Shaughnessy’s Predicting the Markets of Tomorrow has a really interesting chapter on behavioral finance, which is the study of how emotions and cognitive errors influence investor decision-making. In other words, even though we may know what’s the right thing to do, we often allow our emotions to make our decisions for us. This can be detrimental to our investing success.
O’Shaughnessy then goes on to list several emotional pitfalls that most of us are guilty of:
Shortsightedness – We put too much emphasis on the here and now and expect the recent past to carry on into the future. Lots of people fell into this trap during the internet stock bubble of the late 90s. Everyone was talking about how we had entered a new era and that investing would never be the same. We were bombarded with stories about people just like us making millions of dollars by sinking their entire savings into a dot-com. It’s hard to resist that kind of temptation.
Overconfidence – Let’s face it: we all think we are above average and we place too much confidence in our investing abilities.
The Fear of Regret – Investors tend to sell their winning investments too soon and hold on to their losing investments too long. We would rather realize our winners than our losers. The book also mentions that the fear of regret could also explain why people tend to follow the herd. To some people it doesn’t hurt as bad to lose money as long as lots of other people are losing it with them.
The Availability Error – This ties in to shortsightedness. People overweight information that is easy to recall. Think back to the internet bubble.
The Halo Effect – As O’Shaugnessy says:
“…we tend to judge others on the prestige of tehir position or distintion of the their employer. when an analyst from a blu-chip investment house offers advice, we are inclined to believe that his or her opinions are much better than our own. Rather than acut5ally questioning the validity of what he is saying, we enow him with abilities he might not possess.”
In other words, we pay more attention to the messenger than the message.
Representativeness – We tend to see things the way we think they should be. LOL! I’m very bad with this one. Where this comes into play with investing is that we often times think a great company will be a great investment. A really good book to read on this topic is Jeremy Seigel’s The Future For Investors, which I think is a must read for any investor.
So, how do we combat these natural instincts? O’Shaughnessy states that the most successful investor are those who have a system in place to guard against emotional decisions. I agree. Here’s a few other ideas I can think off the top of my head:
1. Dollar-cost-average. Investing the same dollar amount on a continual basis will allow you to take advantage of down markets and keep you from buying too much in up markets. Besides, with 10, 20, or 30 or more years until retirement, there’s really no other way for people to invest.
2. Set up an asset allocation and rebalance it every one to two years.
3. Remind yourself that you are a long-term investor. When times get tough, remind yourself that you are in for the long haul. Don’t check your 401(k) balance on a down day if you think it will cause you to “want to do something.”
4. Remember that asset classes tend to revert to the mean. In other words, if something is up 20% in one year but its long-term average is 10%, you can expect to eventually revert back to that 10%, which means it will most likely underperform in the future. Again, this is a perfect reason to rebalance your asset allocation every one to two years.
This was a fun post for me to put together. Expect more of this sort of thing in the future.