Sometimes, investors are their own worst enemies. Research has shown how our personality types and behavioural biases could lead us into poor investment decisions.
Here are some of the most common mistakes to be aware of.
When a fund is wildly successful it can cause a stampede, but the line “Past performance is no guarantee of future performance” happens to be true so it could pay to resist the urge to follow.
In a 2012 study,1 researchers at Standard & Poor’s tracked over 1,000 mutual funds. Over five years, only about 5% of the funds maintained top-half performance rankings over five consecutive 12-month periods – chance alone would have suggested 6% would repeat.
Performance is informative. But it needs to be analysed over the long term, and as part of a range of factors. Resist following the herd and latching on to trends based on recent events.
You buy what you see as a promising investment. It loses value. You dig in and wait for it to bounce back, so you can sell when it breaks even. Its value creeps back up – but you still don’t sell. If you just wait a little longer, you tell yourself, this stock will finally soar, and vindicate your original decision. You’ll have been right all along…
Holding on to losing stocks for too long – and the converse behaviour of selling rising stocks too early – is a tendency known as “disposition effect”.
A reluctance to swallow your losses is a common emotion. It’s natural to want to keep hope alive. Try to summon objectivity, and avoid holding on to stock long after it should have been sold.
A short-term dip can be alarming – but it might pay to hold your nerve.
An aversion to short-term loss is natural. What can be damaging is to focus on avoiding all such losses, to the point of ignoring a much greater danger – that your funds will be insufficient over the longer term.
It’s a tendency that has been dubbed “reckless conservatism” by David Blake and Alistair Haig of A2Risk. Haig, who also teaches finance at the University of Edinburgh, sums up the attitude of afflicted investors: “They see the prospect of an uncomfortable journey as being so bad that they end up being unlikely to make it to their destination.”
He adds: “The challenge is to reconcile investment risk – what might be characterised as the ups and downs of the market – with the risk that your savings might not be sufficient to meet your needs, particularly if you have quite a long investment horizon.”
Most human decisions are a balance of emotion and reason. Unless you opt to put complete trust in a robot trader, emotion is going to play a role in any investment. But if you set trading disciplines and stick to them, you could counter your emotional responses (such as the urge to cling to losing stock as above).
Of course the rules you choose to follow have to be sound ones. Ideally they will succeed, which means this approach is one best used by investors that have gained longer experience. And once they’re in place, don’t be tempted to tinker with your rules too often if you don’t have to – that could defeat their purpose.
“Professional investors have processes in place, and if nothing else have colleagues to provide some tension and discipline,” says Alistair Haig. “For individuals, a bit of structure could go a long way.”
When asked how they rate their driving ability, most people rank themselves above average. Clearly, they can’t all be right. Some of them are displaying overconfidence. It’s dangerous in driving, and potentially dicey in investment too.
Guard against so-called “self-attribution bias”, which leads investors to blame external factors for bad outcomes while congratulating themselves for good outcomes. This can lead to overconfidence.
There’s a long history of research into the link between overconfidence and trading losses, but it’s not completely conclusive, but one to watch out for.
Investing with local companies or brands you’ve heard of might make you feel more comfortable, but it’s not necessarily logical.
“Familiarity bias” is the term for a tendency to plump for well-known or local investments.
“Retail investors invest in companies which have some kind of brand,” Haig observes. “Very few opt for companies in fields such as support services, for example, which have a low profile.”
Diversifying your portfolio so it includes an appropriate mix of investments can help overcome familiarity bias.
The way you think about your investment has a bearing on your satisfaction, if not your returns.
For example, Reshma and Mark make the same investment. Its value grows by 4% over a year. Over the same period, the market average rises by 6.5%.
Mark is disturbed by what he sees as a loss of 2.5%. Reshma, focusing purely on the investment return, is just glad to have made a nice gain.
Reshma is no richer than Mark as a result of the investment, but she’s happier. “Framing” your returns from a different perspective isn’t a strategy for good investment, exactly – but it can certainly help to mitigate the disappointment that visits any investor over time.
There may be little we can do about our personalities, but building an awareness of behavioural science could potentially help us to side-step some of the most common pitfalls.
Contact your Private Banking and Advice Manager if you would like to discuss your investment goals.
1 Does Past Performance Matter? S&P Persistence Scorecard – Soe and Luo, June 2012:
2 Handbook of the Economics of Finance Volume 2A – Corporate Finance, G. M. Constantinides, Milton Harris, Rene M, Stulz
The forecast of future performance is not a reliable guide to actual future results. The value of investments may fall as well as rise.
This article has been provided to Lloyds Bank by external/third party contributors and contains their views as of August 2016 and should not be relied upon as fact and could be proved wrong. The information and opinions may not be accurate after this date. The views expressed may not reflect the views of Lloyds Bank plc. This article does not constitute advice and should not be relied upon when making investment decisions.
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