“We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
– Warren Buffett.
Successful investing is hard, but it doesn’t require genius. In fact, Warren Buffett once quipped, “Success in investing doesn’t correlate with I.Q. 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.” As much as anything else, successful investing requires something perhaps even more rare: the ability to identify and overcome one’s own psychological weaknesses.
Experts in the field of behavioral finance have a lot to offer in terms of understanding psychology and the behaviors of investors, particularly the mistakes that they make. Much of the field attempts to extrapolate larger, macro trends of influence, such as how human behavior might move the market.
In this lesson we’d prefer to focus on how the insights from the field of behavioral finance can benefit individual investors. Primarily, we’re interested in how we can learn to spot and correct investing mistakes in order to yield greater profits.
Overconfidence refers to our boundless ability as human beings to think that we’re smarter or more capable than we really are. It’s what leads 82% of people to say that they are in the top 30% of safe drivers, for example. Moreover, when people say that they’re 90% sure of something, studies show that they’re right only about 70% of the time. Such optimism isn’t always bad. Certainly we’d have a difficult time dealing with life’s many setbacks if we were die-hard pessimists.
However, overconfidence hurts us as investors when we believe that we’re better able to spot the next Microsoft (MSFT) than another investor is. Odds are, we’re not. (Nothing personal)
Studies show that overconfident investors trade more rapidly because they think they know more than the person on the other side of the trade. Trading rapidly costs plenty, and rarely rewards the effort. We’ll repeat yet again that trading costs in the form of commissions, taxes, and losses on the bid-ask spread have been shown to be a serious damper on annualized returns. These frictional costs will always drag returns down.
One of the things that drive rapid trading, in addition to overconfidence in our abilities, is the illusion of control. Greater participation in our investments can make us feel more in control of our finances, but there is a degree to which too much involvement can be detrimental, as studies of rapid trading have demonstrated.
Don’t be too quick to dismiss psychology as a factor in your development as a successful investor. Being aware of how you think, why you react in certain ways and what biases or beliefs you might have that subconsciously affect your decision making will increase your skills as investor. Not controlling the emotions you might experience such as fear, greed, pride, ego or denial, may impact on the way you invest and, more importantly, on the decisions you make concerning your investments.
Most investors initially think that all they have to do is find the ‘right’ strategy, make an investment, follow their plan and everything will be fine. Doing this though is easier said than done. For example, you have made your investments and built your carefully planned portfolio but along comes the first major correction in the share market and you start losing money. How are you going to react and what will you feel? Most new investors (and even some more experienced ones!) will watch as the value of their investments falls and the emotion of not wanting to lose money means that they hold onto a position in the ‘hope’ that one day it will recover.
Studies have shown that people suffer almost twice as much pain losing $1 as they would feel pleasure in gaining $1 (Kahneman and Tversky, 1991) and this is what motivates investors to hold onto losing positions rather than selling to preserve their capital so that they can invest another day. In this situation emotion is hijacking our decision making skills. Even though we know that we should ‘cut our losses early and let our profits run’, we hold onto a position with the view that until we actually sell the position we haven’t actually made the loss – or that is our rationale, even though it isn’t a logical one.
Common mistakes and how to overcome them:
Are you emotionally attached to your investments?
Everyone has a favourite city to buy homes or favourite stock but when you become emotionally attached to a particular investment this can cloud your judgement. When you are emotionally attached you may ignore your money management rules or ignore negative information that the market is telling you about a position. You are making decisions with your emotions rather than your head and this can lead to disaster. Instead, become attached to the effectiveness of your investment plan which lets you enter and exit a position with a calm, focused and disciplined approach.
What losses are you prepared to take?
Accept that every investor does not make successful investments all the time and that it is normal and acceptable to take a loss. To help, determine and accept your maximum loss amount as you enter an investment. Make sure this amount is an amount you are comfortable with. If 2% of your portfolio is too high for you as a risk amount on any investment then reduce it to a percentage that you are comfortable with. Understand that to be successful you can’t afford to lose too much. Manage your risk, take your losses when your investment plan says and don’t let the small losses turn into big ones. Take your losses as part and parcel of the business of investing and above all preserve your capital so that you can continue to invest.
Investing should be a rational process but we often make it an emotional one. If you spend the time to gain a better understanding of how you think, become aware of your flaws and develop discipline to combat negative psychological effects, you should become a more effective and successful investor.
Have any thoughts and comments?