Morningstar director of personal finance Christine Benz recently interviewed Jason Zweig, author of Your Money and Your Brain, about the latest thinking in behavioural economics, a field that examines the intersection of psychology and financial situations. This article from our Learning Centre can tell you plenty more about the decision-making process and how to avoid falling into the usual investor traps.
Psychology plays into many well-documented--yet surprisingly still common--investing mistakes. While advice like "buy low, sell high" strikes most investors as painfully obvious, there is still a great deal of buying high and selling low. Why? According to Zweig, it's the way we are wired.
But despite the brain's hardwired hang-ups, there are certain steps you can take to help dodge the pitfalls. Below are common portfolio mistakes, and tips to overcome them.
Trading too often
If you constantly check your portfolio, you will 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 and set a schedule
for rebalancing. At most, rebalance quarterly. Setting a guideline for
yourself ahead of time will help you stay disciplined and will save you
money on transaction fees.
Failing to rebalance
The opposite extreme is also problematic. If you don't check up on your
portfolio and rebalance, you can end up with a substantially different
risk profile than you intended. Your portfolio will be skewed to areas
of the market that have performed well in the past and will be
underweight in areas that have lagged. Check your portfolio at least
once per year, but only rebalance if your allocations are significantly
off.
Take a look at this step-by-step guide to rebalancing.
Being unwilling to sell
This error can happen with either a stock that is performing well or a
stock that has underperformed. When stocks are rising, it's
understandable that you want to hold them in case they continue going
up. After all, you rationalise, why would I sell now if I can hold it a
while longer and possibly see an even higher return? But this creates a
situation in which the present never looks like the right time to sell,
and you end up never taking profits. When selling, think about whether
it is a good time to sell, not whether it is the best time to sell.
On the other hand, if you purchased a stock that has languished in your portfolio, the natural tendency can be to hold on to it and try to at least break even. The problem? It might never happen, and waiting it out ties up money that could be deployed in other, more promising investments. Be prepared to acknowledge when the story has fundamentally changed, and know when you need to cut your losses.
Morningstar's fair value estimates can help you separate your emotions from the decision and figure out if you should buy or sell based on the underlying fundamentals of the company. Click here for more information on how to value stocks yourself.
Buying what's 'hot'
An easy way to end up in the above situation is buying a company or
sector when it's all the rage. A good sign something is set to fall? It
is being discussed everywhere you turn as the next great investment.
Many media outlets hailed tech stocks as the next best thing all the way
up to the dotcom collapse in March 2000, and that missed call was not an
aberration. For a pointed look at media insight (or lack thereof), read this
article.
As Zweig says, "whatever feels the best to buy today is likely to be the thing you'll regret owning tomorrow." Morningstar's investor returns show this phenomenon at work. Investors tend to pour money into funds after they've performed well and rush for the exits after they underperform, resulting in much lower returns (or even losses) for average investors compared with funds' reported returns.
The bottom line: Beware of groupthink.
Ignoring expenses
Failure to look at fund expense ratios can cost you precious percentage
points in returns. Research has shown that funds with the lowest expense
ratios also tend to outperform over time. Morningstar's director of fund
research Russel Kinnel explains: "Over a 10-year span, stock funds whose
annual expense ratios are among the cheapest 20% in their categories are
1.4 times more likely to outperform and survive those in the
second-cheapest quintile. And the least-expensive funds are 2.5 times as
likely to outperform and survive those with expenses in the highest 20%
of their categories."
Looking at your accounts in isolation
It's easy for your investments to become messy over the years as you
spread your money between your pension plan, ISA, and taxable accounts.
Of course, different accounts may serve different purposes, and you may
be more aggressive in some than others. But holding dozens of
investments in several different accounts earmarked for the same goal
can be problematic. Your overall allocation may be different than you
realise, and you will probably have overlap between funds and stocks.
You can use the Morningstar's Instant X-Ray tool to see the overall asset allocation and stock overlap of your entire portfolio. You may have higher exposure to a particular stock or sector than you realise.
