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HOW PSYCHOLOGY AFFECTS YOUR INVESTMENT PROGRAM…
AND WHAT TO DO ABOUT IT
by Terry Fay
Most individual investors, no matter how knowledgeable or experienced, eventually fall prey to psychologically induced biases that cloud their judgement and result in poor investment decisions.
None of us want to admit to being irrational. But human beings have emotions, and it is extremely difficult to keep emotions from playing havoc with your investment program. Rational investing behaviour often runs counter to deep psychological tendencies. As well, human beings generally lack the cognitive ability to accurately measure risks and rewards. Most people are simply not wired to fully understand probabilities.
Although an investor may start out with the best of intentions following a carefully formulated investment plan, emotions, misconceptions and irrational beliefs can lead to poor decisions and derail the strategy.
8 Common Investing Mistakes
1. Loss Aversion
If you are like most people, you are not risk averse. You are perfectly willing to take on extra risk appropriate to your circumstances in exchange for the potential for extra return. But what happens when instead of providing this extra return, your stocks go down? The natural human tendency is to hang on to losing stocks in the hope that they will rise again. This is because most people are loss averse, not risk averse.
2. Regret Theory
When a stock falls, we feel responsible for making a bad decision and a feeling of regret sinks in. This feeling can make us hang on to losing positions, even if the evidence shows that the basis for the original investment has changed. To protect their ego, investors hold on to losing positions in the hope that the market (i.e. other investors) will vindicate their judgement and prove them correct in the end. This generally has a negative effect on portfolio performance.
3. Overconfidence
People tend to be overconfident in their own predictive abilities, both in picking individual stocks and in timing the market. Most people believe they are above average. Of course, we can’t all be above average. Not only does overconfidence lead to poor investment choices, it incurs excessive trading costs.
4. Anchoring
Investors generally assume that recent prices are correct. An anchoring bias causes investors to react slowly to new information and expectations about future profits of companies (or the outlook for the companies). Anchoring may also cause us to assume that a recent trend will continue into the future and cause us to extrapolate from what may simply have been a run of good luck.
5. Mental Accounting
Investors tend to engage in mental accounting: that is, to look at investments separately rather than in the aggregate. We think about risks one by one and fail to see that a decision involving one account will affect the bigger picture. This can result in a cafeteria style of investing whereby the portfolio is comprised of a randomly selected group of investments with no consideration to how they will all act together.
6. House Money Effect
Derived from the gambling term where gamblers take more risk with winnings than with their initial capital, the house money effect in the investment world is a version of mental accounting whereby investors have different mental accounts for initial invested capital and another mental account for earnings. This can lead to taking more risk after making a gain.
7. Herding Instinct
Also known as crowd psychology or peer pressure, we buy what everyone else is buying. This way if the investment doesn’t work out, our ego is protected, since everyone else was buying it too. The technology run up of the late 1990’s is a prime example of the herd mentality in action. We all know the outcome of that story.
8. Overreaction
Investor overreaction to information and market events has a powerful effect on stock prices. Investor reaction to earnings announcements is a prime example. If a company’s earnings fall below expectations, investors can be quick to express their dissatisfaction with corporate management and oversell the stock. Taken to the extreme, investor overreaction can lead to speculative bubbles and stock market crashes.
The Solution: Invest Like an Institution
Institutions such as pension funds manage their money differently than individual investors. On the whole they tend to be more objective and dispassionate. Since they act on behalf of the ultimate beneficiaries of the plan they don’t generally succumb to all the usual emotions and reactions individual investors struggle with when dealing with their own money.
A successful institution has a clear definition of what they are trying to achieve and a means to assess if those objectives are being met. They seek to incorporate “best practices” techniques and controls that enable them to make the best decisions.
Today, investors with minimum investments of $25,000 in RRSP’s and $50,000 in non- registered plans can have access to institutional management. We will help you determine your investment objectives and clearly document a strategy. Recommend the best use of experts for your situation as well as the correct asset allocation to meet your risk tolerance. Set in place automatic rebalancing and provide quarterly monitoring and reporting.
If you answered “a.” to one or more questions in our RATIONAL INVESTOR QUIZ, emotions and cognitive biases may affect your investment strategy. You may benefit from a disciplined asset allocation program. These programs take the emotion out of investing and provide an objective, long-term investment solution to help you meet your investment goals.
Please contact me to find out how these investments can play an important role in your financial planning.
RATIONAL INVESTOR QUIZ
Are You a Rational Investor?
1.You are about to buy a toaster for $50, when a friend tells you the same toaster is available at a store about 10 minutes away for $40. You drive to the second store. A week later, you are about to purchase a car for $25,000, and a friend tells you the same car is available at a dealer about 10 minutes away for $24,990. Do you:
a. Drive to the second dealership
b. Buy the car at the first dealership
2. When you go on vacation are you more concerned about the risks of:
a. Flying in an airplane
b. Going on a driving trip
3. You purchase shares of Prospect Co. at $40. A week later, some bad news about the company is released which will almost certainly have negative long-term consequences for the company and the shares drop 10%. You:
a. Sell your shares at $36.
b. Hold the shares in the hopes that the price will rebound and you’ll at least break even.
4. Are you a better than average driver?
a. Yes
b. No
5. Do you sometimes have a feeling that you know what the stock market is going to do on a given day?
a. Yes, sometimes
b. No, never
Explanation of Answers:
1. $10 is $10, but when it comes to money investors tend to evaluate the value of utility of the difference rather than the absolute difference.
2. We have difficulty understanding probabilities, whether probable outcomes of buying shares of a company or safety of different methods of travel. As well, we pay more attention to high drama, low probability events than we do to low drama, higher probability events. Despite copious evidence to the contrary, more people are afraid of flying in an airplane than driving in a car.
3. Investors view paper losses differently. Loss aversion and pride causes us to hang on in the hope that we will eventually be “proven right”. As well, confirmation bias –investors only seek information that confirms their previous ideas or actions – means they can be blind to new information that counteracts their beliefs.
4. You may in fact be a better driver than the average driver. However, in studies 80% of people answer that they are better than average, a result that clearly can’t be true. The same applies to investing; most people believe they are better than average stock pickers or market timers.
5. People are generally overconfident in their abilities to predict outcomes, including whether the market will rise or fall. As well, we tend to have an inability to accept randomness. The stock market is unpredictable; no one knows what it is going to do on any day.
This article was prepared by Terry Fay who is an Investment Advisor with Dundee Securities Corporation, a DundeeWealth Inc. Company. This is not an official publication of Dundee Securities and the author is not a Dundee Securities analyst*. The views (including any recommendations) expressed in this article are those of the author alone, and they have not been approved by, and are not necessary those of Dundee Securities.
The particulars contained herein were obtained from sources which we believe reliable but are not guaranteed by us and may be incomplete. The opinions expressed have not been approved by and are not those of DundeeWealth Inc., its subsidiaries, or its affiliates, including, but not limited to Dundee Securities Corporation, Dundee Private Investors Inc. / Ltd., Dundee Insurance Agency Ltd., Dundee Bank of Canada and Dundee Mortgage Services. This website is not deemed to be used as a solicitation in a jurisdiction where this Dundee representative is not registered.
Insurance products provided through Dundee Insurance Agency Ltd.
Only securities related products and services referenced are offered through Dundee Securities Corporation.
Dundee Securities Corporation, Member CIPF, is a DundeeWealth Inc. Company
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