One of your worst enemies as an investor is you. Unfortunately, the fact that you’re a human being will inevitably get in your way, according to research.
No matter how savvy you think you may be, you’re likely to buy stocks and mutual funds when you should avoid them, or sell them when you should hold them.
But you can protect yourself from yourself. The key is to know the psychological factors that tend to drive dumb investor behavior.
Some investors fight their inclination to be human by turning to machines. Investment professionals nicknamed “quants,” for quantitative research, set their computers so that they buy and sell stocks when the machine sends the right signals based on investment theory, data and historical trends.
The goal is to take the emotion out of decisions to buy or sell securities. Even if you think you’re rational rather than emotional, humans tend to be pulled by factors such as risk avoidance. And while steering clear of risk sounds smart, the common psychological response is to inadvertently take on more risk in an attempt to avoid risk.
For example, people who are afraid of losing money on a stock, tend to hold it as it plummets because they feel better taking no action than to confront the loss.
Money managers often emphasize in presentations to new clients that they have detailed “disciplines,” which they follow so they don’t get emotionally involved with a stock. And some fund managers have extensive disciplines.
Brazos Small Cap Growth, for example, sells stocks that fall more than 20 percent from the fund’s cost in a flat or rising market. Cabot Market Letter recommends investors sell stocks whenever they have fallen 20 percent.
But you don’t have to be that rigid, or be a computer geek, to control your natural human inclinations. The No-Load Fund Analyst, an Orinda, Calif., mutual fund newsletter, recently outlined disciplines individuals can use that will make them better investors. Here are some of the most common problems investors encounter and the solutions No-Load Fund Analyst suggests you use:
– Don’t tie decisions to an insignificant number. The price you pay to buy a stock is significant only to you. No one else cares what you paid, and the stock certainly has no feeling toward you or a memory of its past.
But emotionally the price you paid takes on great significance. You assume, for example, that a stock is worth $50 if you paid $50. And if it suddenly falls to $25, you still think the stock is worth $50 because that’s your price.
The true value of the stock depends on how the company is operating, where it stands competitively in the marketplace, and how investors view the stock compared to other investment choices. And that can change dramatically after you buy a stock.
Your challenge as an investor is to figure out if the stock has fallen because it truly is worth $25, or whether other investors simply are avoiding the stock temporarily because the herd overreacted to some short-term bad news. Either is possible. You need to think about it rather than being wedded to the price you once paid.
No-Load Fund Analyst suggests you free yourself from focusing on the price you first paid by forcing yourself into a different scenario. Imagine that you just returned from vacation and found out your broker got mixed up and sold all the stocks you owned while you were gone. With all the cash in your account, which stocks would you buy again, why would you buy them and at what prices?
Confront your emotions. Ask yourself if you are afraid of taking a loss, and remind yourself that you could buy something else that might do better. Think about what you could buy, and why or why not it might be a good investment. If you buy a stock write down your reasoning, keep it and review it in the future to make sure it is still valid to hold the stock.
– Watch out for trends that don’t really exist and avoid reliance on the recent past. People naturally look for trends and make decisions on patterns and generalities. Unfortunately, they often will come to a decision without adequate evidence or enough research.
In the last couple of years, investors have avoided small-company stocks and poured money into giant stocks and large cap stock funds. But just because such stocks and funds topped the charts last year doesn’t mean the trend will hold. Stocks perform in cycles, and there have been times when small companies left large ones in their dust. So just looking at last year’s champs can be fraught with danger.
No-Load Fund Analyst suggests looking for alternative patterns and explanations, and to play devil’s advocate with the evidence. For example, some people argue large companies are positioned in today’s economy to do better than small companies because they can buy supplies cheaper than small companies, and have access to better technology and global distribution. Consider the arguments and ask it they hold up. Ask yourself why or why not the trend will continue, and what would happen if it didn’t. What might the worst case scenario be?
– Think of all your investments as a package, rather than separate accounts. Research shows that we behave differently when we mentally compartmentalize different pots of money. For example, researchers asked people what they’d do if they lost a $20 ticket on the way to a show. The majority said they’d go home. Yet, 90 percent who lost $20 in cash on the way to the theater, said they’d still go to the show.
No-Load Fund Analyst suggests this thinking leads people to take chances with their investments when they shouldn’t. In a 401(k) plan, they may invest their employer’s contribution in a very risky fund, but be conservative with their own contribution, thinking one pot is their money, while the other is free money. Investors must think about risk-taking in the context of the entire portfolio and their future needs for the money. They also must avoid redundant holdings.
For example, having more than one large cap growth fund isn’t necessary. And if too much money is in that one type of fund, the investor may be taking on more risk than putting a small amount in an aggressive growth fund. Before making an investment, ask yourself what it will do for your entire portfolio.
– Remember that financial advisers are human, too. Like you, professionals also experience emotions that lead them astray. Financial advisers realize that clients pay attention to short time spans, and may get upset if a quarterly statement is disappointing.
Consequently, a financial adviser may not push a client to do what might be best. For example, people shouldn’t be too heavily invested in the stock for the company where they work. A financial adviser may suggest selling a portion and buying something else. But if, in the middle of the process, the new investments are sluggish and the client upset, the adviser may not finish the plan.
The newsletter suggests that investors and their financial advisers decide at the outset how they will evaluate success and over what time frame. Putting it in writing will help.
