In the world of traditional economists and finance professors, though, that's not supposed to happen. If investors are rational decision-makers, then emotion-driven bubbles shouldn't be possible. Yet human weaknesses can limit our ability to think clearly. Many studies of investor behaviour have shown us to be too willing to extrapolate recent trends far into the future, too confident in our abilities, and too quick (or not quick enough) to react to new information. These tendencies often lead investors to make decisions that run counter to their own best interes
ts.
What commonplace mistakes should investors avoid? Here are a few key behavioural-finance lessons worth heeding.
Don't Read Too Much into the Recent Past
When faced with lots of information, most people come up with easy rules of thumb to help them cope. While useful in some situations, these shortcuts can lead to biases that cause investors to make bad decisions. One example is "extrapolation bias," the over-reliance on the past to assess the future. Instead of doing all the necessary and possibly tedious homework in researching a potential investment, investors instead "anchor" their expectations for the future in the recent past. The problem, of course, is that yesterday doesn't always tell you what tomorrow will bring. If you don't believe us, just ask investors who swarmed red-hot technology- and Internet-focused stocks in 1999 and 2000 expecting the good times to continue. They didn't, and most folks ended up suffering huge losses.
That's worth keeping in mind if you're drawn to the strong performers of recent years, whether it's real estate, natural-resources, emerging-markets, or even small-value stocks. While these areas might not be primed for a mighty fall, investors shouldn't expect them to post the torrid gains they've enjoyed more recently.
Realise That You Don't Know as Much as You Think
In a 1981 study asking Swedish drivers to assess their own driving abilities, 90% rated themselves as above average. Statistically speaking, that's just not possible. But most of us are just like the Swedes: We think we're more capable and smarter than we really are. As an investor, you should check your excessive optimism at the door. You might believe you're more likely than the next guy to spot the next Microsoft, but the odds are you're not.
According to several studies, overconfident investors trade more rapidly because they think they know more than the person on the other side of the trade. And all that trading can be hazardous to your wealth, as University of California, Berkeley professors Brad Barber and Terrance Odean put it in their 2000 study of investor trading behaviour. The study looked at approximately 66,000 households using a discount broker between 1991 and 1996 and found that individuals who trade frequently (with monthly turnover above 8.8%) earned a net annualised return of 11.4% over that time, while inactive accounts netted 18.5%. Investors who traded most often paid the most in brokerage commissions, taking a huge bite out of returns.
All of that trading might've been worthwhile if investors replaced the stocks they sold with something better. But interestingly, the study found that, excluding trading costs, newly acquired stocks actually slightly underperformed the stocks that were sold. That means that rapid traders' returns suffered whether or not fees were taken into account. Some researchers have come to a similar conclusion studying fund manager trading--standing pat is often the best strategy.
Keep Your Winners Longer and Dump Your Losers Sooner
Investors in Odean and Barber's study were much more likely to sell winners than losers. That's exactly what behavioural-finance theorists would predict. They've noticed that investors would rather accept smaller but certain gains than take their chances to make more money. On the flip side, investors are reluctant to admit defeat and sell stocks that are underwater in hopes of a rebound. As a result, investors tend to sell their winners too early and hang on to their losers for too long.
One way investors can avoid leaving too much money on the table is to rebalance their portfolios less often. Rebalancing involves regularly trimming winners in favor of laggards. That's a prudent investing strategy because it keeps a portfolio diversified and reduces risk. But rebalancing too frequently could limit your upside. Instead, only rebalance when your portfolio is seriously out of whack with your target allocations. Minor divergences from your targets aren't a big deal, but when your current allocations grow to more than 5 percentage points beyond your original plan, it's likely time to cut back.
You also shouldn't be afraid to sell a loser because it will turn a paper loss into a real one. Hanging on to a dog in hopes of breaking even is a bad idea because you may be forgoing a better opportunity. The trick is knowing when it's time to cut bait. That's why it pays to have clear reasons in mind for your purchase of any investment right from the get-go. If your expectations don't pan out, then it's time to sell.
It's All about Discipline
Fortunately, you don't have to be a genius to be a successful investor. As Berkshire Hathaway chief and investor extraordinaire Warren Buffett said in a 1999 interview with Business Week, "Success in investing doesn't correlate with IQ once you're above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing." It's true that not everyone is gifted with Buffett's calm, cool demeanour. But challenging yourself to avoid your own worst instincts will help you reach your financial goals.
