Six Common Mistakes of Private Investors
Making money in the markets is so simple – if you're an all-knowing genius with no emotions, that is. For the rest of us, it pays to be aware of how our feelings can affect our decisions.
Your favourite team wins, a good friend dies, your child graduates, a colleague is fired – such highs and lows burn our memories deeply, they become part of us. Yet emotion – a core element of being human – often interferes with sound investment decisions. When it comes to building and managing a portfolio, experience and research suggest that sentiment should stay on the sidelines. So, here's a look at a half-dozen of the most common pitfalls.
Running With the Herd
Fear and greed are as active as ever. Witness the countless booms and busts in real estate, equities, currencies and commodities. Easy as they are to spot in hindsight, something about thousands, even millions of people running in one direction is hard to resist. "Many get scared when markets have taken a beating. They cannot see that prices will ever turn upwards," observes Giles Keating, Credit Suisse's Head of Research and Deputy Global Chief Investment Officer. Then, they get overconfident when markets have long been strong. "They think 'I can't afford to miss this', so they get into the market just before it peaks and then falls." In short: they sell low and buy high – surely the most fundamental goof of investing.
A Fine Tale at the Pub
Glistening eyes, nodding heads, appreciative laughter. It all looks and sounds so good when you talk – ok, brag – about how you made a killing in this stock or the other. And of course the sexier the story, the better it tells. "Everybody is enthralled when they learn that you got in early on Apple, or some other successful, well-known stock," notes Keating. "But if you go on about how you built a low-risk, good return bond portfolio…not so much." The issue here is selective attention: keeping a sharp eye on the good or exciting, while ignoring the bad or boring. One problem with this is that, in the end, only overall performance really counts. If your 'cool' holdings are overwhelmed by your 'uncool' ones, no tales of conquests or high-fives will undo the hard, cold numbers. Another drawback to selective attention is that it generally ignores portfolio risk. It's very possible, warns Credit Suisse's Chief Investment Officer for Europe, Anja Hochberg, to end up with all your eggs in one basket, and not even realize until they've all smashed into an uncooked omelet.
Never Learning to Lose
'Step right up, step right up,' says the carnival barker, as he makes you a once-in-a-lifetime offer. Either you can take 80 US dollars, cash in hand guaranteed, or you can flip a coin for 200 US dollars. Heads, it's yours; tails, you get nothing. Although rationality teaches that ½ x 200 = 100 US dollars is of course greater than 80 US dollars, real-life testing shows that a majority of people still will chose the first option, the 'sure thing'. Similarly, various studies have shown that most people would prefer to make a single profit of 50 US dollars rather than first to make a profit of 105 US dollars and then a loss of 50 US dollars. Regrets we've had a few, and most of us try to avoid them. As put so poignantly by Marlon Brando's character in 'On the Waterfront': "I coulda had class. I coulda been a contender. I coulda been somebody, instead of a bum." Memorable as that might be, learning to take losses unemotionally is usually key to long-term success. Say you buy a stock, and for unforeseen reasons it plunges 10 percent. "Some people insist on holding in there and waiting for it to climb back to neutral," Hochberg points out, "even though they might be ignoring a chance to sell and put the money into a vehicle that could earn 30 percent."
Don't Confuse me With the Facts
In a similar vein, investors often fall prey to false first impressions. Psychologists call this confirmation bias: an investment idea sounds good, so it must actually be good. Like a skilled salesperson, the investor then compiles all the right reasons to buy, while ignoring all the right reasons not to. Additionally, some then succumb to hindsight bias. After buying, they then look for evidence to justify the purchase, to confirm that they got it right – even when in fact they got it wrong. "Some investors refuse to take into account negative information that becomes available after the investment is made," Hochberg observes. Being able to see that a decision was faulty – either when it was made, or sometime thereafter – marks a mature investor.
Half Empty or Half Full?
The answer to this classic question involving glasses and their contents might surprise: for investors, it doesn't matter. What really matters is how things will look at the end of the investment period, i.e. will there be more in the glass than when we started? Although this sounds obvious in principle, in practice it can be less so. Research has shown (and good marketers have long known) that 'framing' can influence decisions. For instance, one study found that meat labelled as '75 percent lean' received better customer reviews than the same stuff, badged as '25 percent fat'. Likewise, patients needing surgery prefer operations that offer 90 percent survival rates over those in which 10 percent end in death. When asked to judge the performance of basketballers, people rate more highly players presented positively (she hit 50 percent of her shots) than the same players presented negatively (she missed 50 percent).
Ready, Fire, Aim
Here's one that true marketers – i.e. people who sell things at outdoor markets – have always known. 'Anchoring' a buyer into a high price creates an illusion of value. If the vendor in the Moroccan souk 'sets an anchor' by offering his magic lamp at 500 Dirham, some buyers will be pleased to take it at, say, 250 – even if it's worth only 100. The moral of the story: not knowing the value of an item makes buying (or selling) a fraught experience. Yes, there are many methods and opinions of value, and they won't always agree, but using and mastering them will almost always yield better results than basing investment decisions upon emotion.