Investors Can Be Their Own Worst Enemy

Successful investing is hard, but it doesn't require genius. As much as anything else, it requires something perhaps even more rare: the ability to identify and overcome one's own psychological weaknesses.

Morningstar 22 August, 2005 | 1:22PM
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Behavioral finance has become a cottage industry in recent years, spawning an array of academic papers and learned tomes that attempt to explain why people make financial decisions that are contrary to their own interests.

The concept is not new, however. Benjamin Graham used to portray Mr. Market (and who is the market other than you and I?) as a fellow prone to mood swings, from wildly optimistic to irrationally pessimistic. The key for Graham--and for his disciple, Warren Buffett--is patience.

As Buffett said in a 1999 interview with BusinessWeek, "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." His partner at Berkshire Hathaway Charlie Munger, never misses an opportunity to recommend Robert Cialdini's book “Influence”, which examines why people give in to pressure from others.

Yet, despite all the warnings, investors continue to exhibit several key behaviors that tend to get them into trouble. Let's go over a few of these counterproductive activities, so that we'll have fodder for the next round of New Year's resolutions.

Checking Portfolios Too Often

Let me be the first to say that I'm guilty here. I look at my stocks [shares] at least a couple of times a day, so I know first-hand what a psychologically painful experience it can be. The problem is that people are generally loss-averse--that is, they experience negative feelings from a $50 loss that are stronger than the positive feelings they get from a $50 gain.

This concept formed the basis for prospect theory, developed by Nobel laureate Daniel Kahneman and Amos Tversky in 1979. Richard Thaler and Shlomo Benartzi went the next step and showed that frequency of evaluation was key to how well an investor could endure losses. Those who do their mental accounting over short time spans, even if they're investing for the long term, earn lower returns.

Again, this is nothing new. Buffett has said that he wouldn't mind if the market shut down for years at a time. For many of us, though, every day becomes another chance to suffer the agony of our investment decisions. Nassim Taleb, who runs a hedge fund (Empirica Capital) that makes its living by enduring short-term pain, points out in his book “Fooled by Randomness” that probability dictates that the market will show a positive return on only a little over half of the days it's open. If losses hurt twice as much as gains, then people who check their portfolios daily will suffer much more than they'll benefit. Thaler and Benartzi calculate that the "psychic cost" of evaluating your portfolio on an annual basis is 5.1% per year, versus 0.6% for a 10-year evaluation period, based on changes in the implied equity-risk premium. Measuring performance on a daily basis seems certain to drive the risk premium even higher, costing investors considerably more than 5.1%.

Do yourself a favor and try to resist the urge to calculate your portfolio value in real time. The quotes may be free, but the total cost can be huge.

Trading Too Often

Frequent evaluation leads, naturally, to frequent trades. Terrance Odean and Brad Barber studied activity in 66,000 accounts at a large discount broker from 1991 to 1996 and came to this conclusion: "Trading is hazardous to your wealth."

They found that individuals who trade frequently (with monthly turnover above 8.8%) earned a net annualized return of 11.4% over that time, while inactive accounts netted 18.5%. Trading costs, in the form of commissions and losses on the bid-ask spread, accounted for most of the difference. Those costs have likely fallen since 1996, as more discount brokers have pressured commission prices and decimalization has reduced spreads, but friction costs remain a drag on overall returns.

But surely investors got some benefit from trading less-desirable stocks for better ones, right? Nope. In fact, Odean and Barber found that, excluding transaction costs, newly acquired stocks actually slightly underperformed the stocks that were sold! That bears repeating: By trading frequently, individuals hurt not only their performance net of fees, but they also hurt their performance before fees.

Why would this be? Odean and Barber believe that it reflects investors' overconfidence in their ability to assess information. It's clear that rapid traders are making unreasonable bets--one would expect that they would trade only when the benefit would offset at least the cost of trading, but that was clearly not the case in this data set. But does high turnover reflect self-assurance, or could it betray the lack of it?

Investors in Odean and Barber's study were much more likely to sell winners. This appears to reflect the desire to "take some profits," while not wanting to accept defeat in the case of the losers. (Philip Fisher writes in his excellent book “Common Stocks and Uncommon Profits” that "more money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other single reason.") Such a tendency would be in keeping with myopic loss aversion: People may view losses as more likely in a stock that's up than one that's down. This attitude would also mesh with another common trait, framing evaluations on meaningless benchmarks, such as what price you bought a stock.

Perhaps, then, investors aren't confident in their understanding of their investments and simply worry that they could lose their gains. They may feel more comfortable jumping into an investment that others currently recommend.

Getting Distracted by Shiny Objects

There are thousands and thousands of stocks out there. Investors cannot know them all; in fact, it's a major endeavor to really know even a few of them. But people are bombarded with stock ideas from brokers, television, magazines, Web sites, and other places. Inevitably, some decide that the latest idea they've heard is a better idea than a stock they own (preferably one that's up), and they make a trade. Unfortunately, in many cases the stock has come to the public's attention because of its strong previous performance. When this is followed by a reversion to the mean, new investors get burned.

This is not to say that an investor should necessarily hold whatever investments he or she currently owns. Some stocks should be sold, whether because their underlying businesses have declined or the stocks simply exceed their intrinsic value. But it is clear that many individual (and institutional) investors hurt themselves by making too many buy and sell decisions for too many fallacious reasons. We can all be much better investors when we learn to select stocks carefully and then block out the noise.

This article originally appeared on www.morningstar.com.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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