The Biggest Stumbling Block to Your Investment Success: YOU!

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.

9 thoughts on “The Biggest Stumbling Block to Your Investment Success: YOU!”

  1. Excellent post. I would only point out that we must remember that short-sightedness works both ways. Just as peopel thought the market would always go up during the internet bubble, there were lots of people who got out of the market at the bottom in 2002 thinking it would never go up again. These are the same types of people who are now renting instead of buying because they think that the housing market is doomed and will never recover, and will probably buy again after the rebound has already occurred.

  2. Great post! My three guiding principles of investing are diversify, minimize costs, and GET OUT OF THE WAY.

  3. I think I’ve made most of those mistakes at one time or another. Fortunately, thru the lessons of my mistakes, I eventually, settled on a system much as one you described.

  4. Great run-down of the stumbling blocks we erect for ourselves as people and as investors. Focusing on the long-term will solve most of these problems!

  5. A question about dollar cost averaging: I agree with the idea, but with the exception of the 401k, don’t you need to take broker costs into account? – what do you suggest would be the minimum amount to invest assuming discount broker costs will be paid? – or what maximum percentage of the investment can be eaten by broker costs and at what frequency of investing do you suggest to take advantage of dollar cost averaging?

  6. Dollar cost averaging works best with no load mutual funds where there is no investment fee. Choose Vanguard, Fidelity or T.Rowe Price brokerage and you get their funds at no transaction cost and many other funds with a low or declining back end load.

  7. Phil,

    Yes, you have to take fees into consideration when dollar-cost-averaging. As “ciwood” says, look for low-cost funds like Vanguard, Fidelity, or T. Rowe Price. Some of them allow you to start with a small amount and won’t charge you an arm and a leg as long as you sign up for their automatic plan. If there is an initial minimum to meet, consider saving your money in an account at ING Direct or GMACBank.

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