Investment Psychology

investment-psycologyOver the past ten years or so, there has been a lot of literature about investment psychology, more often referred to as Behavioral Finance“A field of finance that proposes psychology-based theories to explain stock market anomalies. Within behavioral finance, it is assumed that the information structure and the characteristics of market participants systematically influence individuals’ investment decisions as well as market outcomes.”

For many years, most financial scholars maintained that markets are rational and efficient, and this was embodied in the “Efficient Market Hypothesis.” However, the many manias and wild market swings throughout history have undermined this theory.

“In the short term, the stock market behaves like a voting machine, but in the long term it acts like a weighing machine”
– Reknowned investor Ben Graham, whose followers included Warren Buffett and Peter Lynch

Many investors have suffered huge losses from buying into popular asset manias near the top. Similarly, the lost opportunities from selling temporarily unpopular but cheap assets at or near the bottom devastate long-term results because of the powerful effect of compounding, which multiplies the effect of large errors. Here are a few examples:

  • In 1987 the market crashed 22% in one day, but still rose over 5% for the year. Those who sold at the bottom and stayed out for two years missed returns of 53%.
  • The DJIA hit a market low of 6,443 on March 6, 2009, losing 54% of its value since the October 9, 2007 high of 14,164. The bear market reversed course on March 9, 2009 and as of January 1, 2015 stood at 17,823, a gain of 272% from the low. Those who bought at the top lost big and those who sold in fear in 2009 at the bottom missed the recovery.

The table below depicts how the new economy stocks of the internet bubble ruined investors. There are many other examples throughout history.

Source:  Malkiel, “A Random Walk Down Wall Street,” 2007, p. 81.

Source: Malkiel, “A Random Walk Down Wall Street,” 2007, p. 81.

The lesson is clear: investor behavior is a major determinant of investment performance. Investors might have perfect understanding and an excellent investment strategy, but their investing results will be determined by their behavior.

Psychological Challenges with My Approach

It is important to understand that there are significant behavioral challenges to following my recommended approach:

  • Bucking the desire to be active – doing nothing vs. being active.
  • Sticking to your guns in a down market.
  • Ignoring the hot new investment opportunity.
  • Ignoring your friends who are making big money on a specific investment, or making a larger allocation to stocks than you in a bull market, or less than you in a bear market.
  • Ignoring investment, political and business news media hype.
  • Being comfortable with a different approach.
  • Experiencing “tracking error,” whereby your portfolio may underperform the popular market averages in a given timeframe, creating remorse about not being fully invested in U.S. stocks.

This is where an investment advisor can provide value by providing an objective check and balance on your behavior.

Mistakes that Even Smart Investors Make

One of my favorite investment books is “Investment Mistakes Even Smart Investors Make and How to Avoid Them,” by Swedroe and Balaban. I believe this is must reading for all investors. It is an easy read for all levels of investors and lists 77 mistakes. Each chapter is succinct, backed by compelling data and provides actionable advice.

Below I list what I believe are the Top Ten Mistakes (those having most effect on your performance). Not every item on my list exactly matches one in the book, because I have modified and/or added insights based on personal experience and research (and yes, I have made some of these mistakes).

My Top Ten Investor Mistakes

  1. Attempting to time the market.
  2. Not adopting and/or sticking to a long term investment strategy.
  3. Relying on bad advice from the wrong sources (e.g. brokers, TV analysts, or [soon-to-be ex] friends).
  4. Investing in expensive mutual funds with loads and/or high expense ratios.
  5. Chasing performance of recent winning assets or managers.
  6. Adopting the wrong mix and/or weighting of assets – not having an investment strategy.
  7. Not managing your assets properly to minimize taxes.
  8. Investing based on hot tips or too good to be true “opportunities.”
  9. Not understanding the risk-reward tradeoff of your individual and total portfolio holdings; not building a portfolio that as a whole maximizes your results.
  10. Being too active – buying, selling and changing holdings too much.

I can’t emphasize enough the importance of self-awareness in your investing. Just by reading about it you can gain more awareness of your tendencies and possible weaknesses, thereby helping you to avoid these mistakes.

Here are more resources that can help you:

Background/Concepts:
Investopedia University: Behavioral Finance
Bogleheads: Behavioral Pitfalls

Research Paper:
Library of Congress: Behavioral Patterns and Pitfalls of U.S. Investors (pdf)

Books:
The Four Pillars of Investing, by William Bernstein
Your Money & Your Brain, by Jason Zweig

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