OK, I’ll fess up. In my years of investing, I’ve done all of the following:
Sell a stock right away after a quick run-up in price so I could “lock in” a profit and show everybody how smart I was.
– Take the money from the sale and, feeling I was “playing with the house’s money,” reinvest it in a riskier stock.
– Watch the new stock sink so low it erased all profits from the sale and saddled me with additional losses. (Naturally, the stock I had sold continued to rise.)
– Now the clincher: Not wanting to admit I had made a mistake, I held onto the losing stock much too long before I finally got rid of it.
If you also have done this, it means you fell prey to what Washington State University finance professor John R. Nofsinger calls “common psychological biases” that trip up most investors.
“I’ve done a lot of these things myself,” said Nofsinger, author of the new book “Investment Madness: How Psychology Affects Your Investing … And What To Do About It” (Financial Times Prentice Hall, hardback, $24).
“Investment Madness” also adds some fresh perspectives with examples of how the Internet amplifies the impact of investors’ biases.
One of them is the “illusion of knowledge,” created by the vast amount of information available online. Another is the “illusion of control” because investors can just click and trade. Together, they can lead to overconfidence.
“The benefits of the Internet are offset by the harm done to you if you are affected by these biases,” Nofsinger wrote.
“Investment Madness” identifies three categories of biases: not thinking clearly, letting emotions rule and functioning of the brain.
Not thinking clearly can lead to overconfidence, which in turn may cause you to trade too much, incur higher transaction costs and achieve poorer results. It also can result in a tendency toward the “status quo bias” (leaving things as they are, even if a much better investment is available), “attachment bias” (becoming emotionally attached to your investments) and “endowment effect” (demanding more to sell something than you would pay for it).
The emotions that may rule your actions include pride and regret. They may induce you to sell winning investments too soon or hang onto losers too long. You may also take excessive risks in your emotional desire to “break even” when you have a loss, and suffer bigger losses instead.
The discussion on functioning of the brain shows how people filter information, alter recollections and rely on stereotypes and previous experiences. One example: You want to believe your decisions are good and therefore may tend to dismiss new negative information about your investments.
To overcome your biases, Nofsinger suggests five strategies:
– Understand your biases.
– Know why you are investing. Write down specific goals, such as how much money you need when and for what, so you can look at the “big picture” and determine whether your behavior matches your goals.
– Have “quantitative investment criteria,” that is, based in numbers, so you avoid investing on emotion, rumors or other psychological biases.
Examples of quantitative criteria for stocks include price-to-earnings ratios and rates of sales and revenue growth.
– Diversify by owning many different types of stocks or a broadly diversified stock mutual fund. Own very little of your company’s stock and invest in bonds, too.
– Control your investment environment. If you’ve been an overactive trader, start checking on your stocks just once a month, not daily or hourly, and confine your trades to once a month, preferably on the same day.
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Humberto Cruz can be reached at AskHumberto@aol.com or c/o Tribune Media Services, 435 N. Michigan Ave., Suite 1500, Chicago, Ill. 60611.
