Why you may be your own worst enemy when investing
BOOK EXCERPT
For a guy who was chief executive and chairman of an investment company that has more than US$7 trillion in assets, Jack Brennan has a nice common wisdom touch for all investors. This year, the former head of Vanguard Group updated his 2002 book and released More Straight Talk on Investing. This is an abridged excerpt from that book.
Economist Benjamin Graham once said “The investor’s chief problem — and even his worst enemy — is likely to be himself.”
The quote captures perfectly that tendency for investors to act irrationally and in ways that are contrary to their own interests.
Over the past few decades, an entire academic discipline has sprung up on this topic — behavioral finance, which is the study of the influence of psychology on investor behavior.
While we investors would like to think we always carefully weigh our options and sensibly choose the ones that offer the most benefits, the fact is that we often don’t. It turns out that real people aren’t very good at even identifying options, let alone choosing the right one.
We tend to misinterpret information and miscalculate simple statistical probabilities. And we react to events in emotional and often counterproductive ways.
Here’s a list of some of seven miscues to avoid.
1. Being Overconfident About Your Own Abilities
Remember humorist Garrison Keillor’s mythical town of Lake Wobegon, where “all the women are strong, all the men are good-looking, and all the children are above-average”?
I have no data about strength and looks, but it turns out to be pretty common for people to think they are above-average in many ways. Numerous surveys have found that a large majority of people believe they are better drivers than most other people, too.
If you are overconfident about your abilities as an investor, you are likely to underestimate risk. Such thinking could lead you to dismiss time-tested principles of investing — balance and diversification, for example — in the belief that you can win big by picking one or two superbly performing funds or stocks.
2. Allowing the Current Environment to Blind You to the Larger Context
People have a tendency to assume that present conditions will continue — whatever those conditions may be. As a result, when markets are very good, investors tend to be overly optimistic, and when markets are bad, investors tend to be overly pessimistic. It is called recency bias.
3. Thinking You See a Pattern Where None Exists
Human beings like patterns and tend to believe they exist even when events are totally random. People also think they can use those patterns to their advantage.
Statisticians explain the mirage of patterns in terms of coin tosses. If you toss a coin five times, the probability of getting heads (or tails) remains 50/50 each time, no matter what the sequence of previous tosses. Each toss of the coin is what statisticians call an independent event. That’s a difficult concept for many people to internalize.
During the 1990s, investors noticed that each sharp drop in the stock market was followed by a sharp recovery. They concluded that quick rebounds were the rule these days and started telling each other to “buy on the dips.” In fact, the markets don’t always rebound quickly, as investors were reminded by the prolonged decline that began in 2000, and a few years later in 2008-2009. (The rebound in 2020 is one of the exceptions to this rule.)
4. Focusing Too Much on Short-term Losses
Investors perceive losses to be more painful, so they sometimes do peculiar things to avoid incurring even a short-term loss. They may hold onto losing funds or securities far longer than they should, waiting to get back to even before they sell. Or, they may sell investments that are rising because they’re fearful of future losses. If you are a longterm investor, you shouldn’t permit this instinctive aversion to loss to cloud your judgment.
5. Feeling Compelled to Do Something — Anything
Even investors who understand the wisdom of the buy-and-hold philosophy sometimes feel uncomfortable doing nothing, especially when so many environmental forces are enticing us to trade, switch providers, try new investment strategies, and so on and on. Thanks to the internet and smartphones, it’s easier than ever to give into that impulse to tinker.
Some people check on their account balances obsessively. Let’s call it the app mentality. By spending just a few minutes looking at your portfolio, you could be tempted to switch from one fund to another or cash out of an investment that seems to be underperforming. Resist the temptation to look at your account balance more than once a quarter, if at all possible.
6. Letting False Reference Points Distort Your View of Value
Anchoring is the tendency of buyers to relate their estimates of value to some previously established benchmark. Without always realizing it, people tend to form opinions based on a reference point that may or may not be meaningful.
In investing, anchoring can cause you to judge the performance of a particular investment in light of factors that aren’t truly relevant — the price you paid for it long ago, its all-time high or low price, or an analyst’s estimate of its future price.
It is difficult to shake an anchor once it’s in your consciousness. For example, if you learn that a prominent financial analyst predicts a stock’s price will rise from $100 to $250 a share, you are likely to conclude that it’s a good value at $150 a share, even if the company’s fundamentals don’t support that valuation.
7. Remembering Things Selectively
Unfortunately, people’s memories are very uneven. We tend to remember our triumphs and forget our failures. You’ve probably noticed that people who regularly go to casinos tend to talk about the times they won, not the trips when they lost. We also tend to remember the tales we’ve heard about people who made a pile in the financial markets by following some scheme or other. We forget about those who swung for the fences and struck out.
How to Foil Your Own Worst Enemy
Have I depressed you enough? At this stage, you may be wondering why you should even bother to try to invest successfully, given that we are all so likely to sabotage ourselves.
But don’t let these examples of investor foibles leave you in despair. The reason the study of behavioral finance is so useful is that it can help us to recognize self-thwarting behavior. Then we have a chance to take preventive measures. Financial Post Excerpted with permission from the publisher, Wiley, from More Straight Talk on Investing by Jack Brennan. Copyright© 2021 by John J. Brennan. All rights reserved. This book is available wherever books and ebooks are sold.