Mind over money
A great deal of economic and financial theory is based on the idea individuals act rationally and consider all available information when making investment decisions. But an evolving field called ‘behavioural finance’ is revealing this is not the case.
Drawing from psychology and other social sciences, behavioural finance attempts to understand what makes investors tick and how this affects the market. It gained authority worldwide in 2002 when Daniel Kahneman, was awarded a Nobel Prize for his work in the area.
Gut instincts
Trading on intuition is the fastest way to lose money. Greed, fear, fight and flight are all natural instincts – a hangover from the days when we had to hunt for our food. So when our wealth is at stake, these instincts tend to kick in. But unfortunately, they are not a good basis for making rational investment decisions.
When we make decisions based on intuition, we rely on quick fixes such as hot tips, current news items and what people we know are doing, instead of approaching the situation logically.
But I know what I’m talking about
Ego is one of the basic drivers of the human mind and research shows most people think they know ‘better than the next person’. This is why we believe we can outperform the market and why we think investment fundamentals like diversification don’t apply to us.
A little knowledge can be a dangerous thing and investors are particularly ‘overconfident’ in areas where they know something. We often trade on what we believe to be superior information, when in fact the market’s probably already factored it into the price. We also tend to forget our mistakes and credit skill for our lucky breaks. This leads to overtrading and poorer results.
The best way to combat the dangers of ‘overconfidence’ is to have a long-term strategy and stick to it! Get all the information you can, seek advice and make a plan. Then minimise your active participation in the market - this way you won’t make instinctive decisions, based on ‘noise’.
Last year’s trash could be this year’s treasure
Chasing last year’s good returns is another common mistake that could end up loosing you a lot of money. This is because past performance is not a good indication of future performance. Take 1994, for example. A chaser would have invested in Australian shares based on high returns of 45% in 1993, only to incur a loss of 9%. In fact, in the last 20 years there has been six examples where last year’s best performing asset class has become the next year’s worst.
It’s also not unheard of for one year’s worst performing asset class to become the following year’s best. In fact this has happened seven times in the last 20 years.1 So while chasers go after last year’s ‘hot sector’, they could be missing out on bigger returns in another sector.
As you can see share markets are quite volatile and long-term investors are bound to run into periods of short-term underperformance. But you need to keep a level head and stick to your long-term plan.
For long-term investors dollar cost averaging is one way to take the guesswork and emotion out of investing. Instead of investing a lump sum all at one time, you could put a fixed amount of money in the market at regular intervals (usually every payday or every month) regardless of whether the market is up or down. This way you will avoid the temptation to buy all your shares when the prices are high.
Of course, diversifying your money over a range of asset classes will also help smooth returns over time.
Fighting a losing battle
While chasing last year’s return may not be a good idea, holding onto shares that are performing badly for a long time may not be a good idea either. It’s human nature to want to hold onto them until you get your money back. But ask yourself if you’d buy those shares again now and if the answer is no then consider whether you should continue to hold them.
Learning from mistakes
The first steps in reducing common investment mistakes are to recognise and learn from them. And there are some measures you can put in place to keep yourself in check:
- Seek advice from a trusted source such a qualified financial adviser. Don’t rely on recent news stories or recommendations from people you meet at barbeques or dinner parties.
- Decide on a long-term strategy that is within your risk tolerance – your financial adviser can help you.
- Take a balanced approach – diversify your investments and consider dollar cost averaging.
- Learn about the long-term history of markets so you’re not startled by short-term downturns.
- Know when to cut your losses.
- Resist the temptation to check on your investments every 15 minutes – fear can induce rash decisions. Remember you’re investing for the long-term.
- When buying or selling, ask yourself whether you are acting rationally based on all available information, or irrationally based on recent news or emotion.
By following these basic rules you can avoid making common investment mistakes, and stay on track with your long-term goals.
1Why you shouldn’t chase last year’s returns, Perpetual Investments, 2006