Behavioural Finance
The study of behavioural finance deals with how humans make financial decisions, and academic research has shown time and again that we are not very good at it. Understanding your tendencies is an important determinant of your success.
My role as an advisor is often to be a coach, to help clients better understand their portfolios and which risks are required to reach their financial goals. It is also important to understand how that portfolio is likely to behave in up and down markets. When your stocks fall 20%, will you want to sell or buy more, and when your stocks rise by 20%, will you be willing to sell some winners and buy some losers?
Ben Graham, the famous investor and professor who taught Warren Buffett once said “The investor’s chief problem – and even his worst enemy – is likely to be himself”.
Here are the three most common mistakes that investors make:
If you find yourself chasing the hot stock or the hot sector, remember you’re not alone - eventually prices get pushed too high, and you can only profit by selling to another speculator. Seasoned investors call this the “greater fool” theory.
Unfortunately it’s impossible to know how far markets will fall, or how quickly they will recover, and this is made more difficult by negative press. By focusing on fundamentals such as valuation and your long-term goals, you will be able to see beyond current events, and today's discounts will appear as opportunities.
Investors are inundated with information, and we have a tendency to go with what feels right. However, over the long-run, details on asset allocation and diversification are more important for determining whether you reach your goals.
Our minds handle this complexity by taking shortcuts, and often we don’t know it’s happening. For example, we feel comfortable doing what others are doing, we avoid decisions on when to start investing, and we use rules of thumb such as weighing everything equally. Even if we know this is happening, it’s hard to turn it off, because we are hardwired to do what “feels” right. However, what “feels right" may have helped us survive for hundreds of thousands of years, today it harms our ability to make smart financial decisions.
Perhaps not surprising then, research has shown that the less often you look at your portfolio, the better your returns. Yet humans tend to feel that value is being added with every trade - some advisors even generate trades that are intended to show special insight. Research shows that the only trades that add long-term value are those that rebalance your portfolio back to long-term targets - essentially, selling winners to buy losers. Of course, it can be fun to try to add value by trading at the periphery, just be sure to have strong core strategy.
Lastly, be sure to choose an advisor that has the financial and academic background to be a sounding board, someone that can determine which ideas fit into the greater strategy for reaching your goals.
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Hard-Wired Biases Affect Our Decisions
Being overly confident is one of the biggest mistakes investors can make. In fact, investors often seek out advisors that display a lot of confidence. The best way to tackle overconfidence is to recognize when it’s happening. Staying humble allows you to think more objectively.
Seeking out or paying attention to information that validates your current opinion. For example, you believe in a sector, and you look for information that supports your view, even when investing in that sector may be speculation. Have an objective way of determining the intrinsic value of an investment.
Focusing on recent events. We all know that the past does not predict the future. Despite that, mutual fund and ETF providers only market their top performing funds to advisors, as if that list will be your best choices for tomorrow. Having said that, there is insight to be found in understanding why a manager may have outperformed or under performed - was it skill or good/bad luck? Similarly, watching the news makes us think we have special insight, yet there are probably millions of people that understand a situation better that you.
Holding onto losers for too long, or selling winners too soon, typically to avoid admitting to a mistake or bad decision. Best to set guidelines on what you’re hoping to achieve, so that facts rather than emotions decide when to buy or sell.
Not taking future needs seriously enough. A great way to manage this is to have a retirement plan which seeks to identify your expected cost of living during your retirement years - now determines how much you need to save to pay for that lifestyle. The next best step is to automate your savings and investment plan.
This one leads us to believe after the fact that a past event was obvious and could have been predicted, while in fact the event could not have been reasonably predicted.
This is the tendency to attribute successful outcomes to your own actions, while attributing bad outcomes to an outside force. Investors not recognizing this bias can easily become overly confident too. It is easy to feel smart when your stocks have risen.
Worrying is natural and very common, and it creates visions which alter an investor's judgment. Anxiety forms, leading to greater perceived risk, which lowers risk tolerance. Regulatory Know Your Client (KYC) questions are designed to help investors match their risk tolerance with an appropriately balanced portfolio. However, in my practice, I've always felt that education and financial literacy are your best defense. The better investors understand what they own, the more likely they are to embrace the risk required for reaching their goals.