How To Avoid Irrational Investment Behavior
In my 34 years as an investment advisor, I’ve watched investors make a lot of mistakes. Part of it is the lack of knowledge. But the most common reason is as humans, we are prone to behavioral errors. People can be over confident of their skills, which could lead to excessive risk taking. To help you avoid these missteps, we’ll tackle some of the more common ones, especially wanting more from investments than returns.
Ego and Investing
One of the leaders in the field of behavioral finance is Meir Statman. To improve your chances in reaching your financial goals, you should read his book, “What Investors Really Want”. This uncovers a lot of errors that we, as investors make. He said: “Investments are like jobs, and their benefits extend beyond money. Investments express parts of our identity, whether that of a trader, a gold accumulator, or a fan of hedge funds. … We may not admit it, and we may not even know it, but our actions show that we are willing to pay money for the investment game. This is money we pay in trading commissions, mutual fund fees, and for software that promises to tell us where the stock market is headed.”
Statman said that driving a Rolls Royce or carrying a Chanel bag with oversized logo is their expression of status, only available to the wealthy. This is just like investing in hedge funds. Statman quoted what John Brooks, a business and finance author, said: “Exclusivity and secrecy were crucial to hedge funds from the first. It certifies one’s affluence while attesting to one’s astuteness.” Statman said that hedge funds offer “the expressive benefits of status and sophistication, and the emotional benefits of pride and respect.” There are investors who complain when hedge funds lower their minimums. Those expressive benefits tell why Bernie Madoff was so successful , and why affluent individuals still invest in hedge funds despite the lousy performance. These are just ego-driven investments powered by the desire of wanting to be “in”.
The desire to be above average
In his book “Investment Titans”, Jonathan Burton wanted his readers to ask themselves these questions:
- Am I better than average in getting along with people?
- Am I a better-than-average driver?
Based on studies, 90% of the population cannot be better than average in getting along with others, and 90% cannot be better-than-average drivers.
Most people believe they are above average, though by definition, only half can be better than average at getting along with others, and only half can be better-than-average drivers. In some ways, overconfidence may be a very healthy attribute. It helps us create a positive framework to get through life’s experiences. Unfortunately, being too confident in our investments skills can lead us to making mistakes. And so does what seems to be the all-too-human desire to be above average.
Statman shows how the desire leads investors to trade too much, and the cost the mistake that can be:
- An American brokerage firm showed the trading records of thousands of investors that the returns of the heaviest traders trailed those of index investors by more than 7% a year, while the lightest traders trailed by only 0.25% per year. That shows that the heavy traders were taking the risks of stocks while earning Treasury bill-like returns.
- A Swedish brokerage firm revealed that on average, the losses of heavy traders is 4% of their net worth each year.
Statman noted that beat-the-market investors trail the market and passive (e.g., index) investors because they tend to buy high and sell low. Here are examples he showed:
- Investors who switched mutual funds frequently trailed buy-and-hold mutual fund investors by about 1% if they switched between large-value funds, 3% if they switched between small growth funds, and 13% if they switched between technology funds.
- Switching hedge fund investors did no better than switching mutual fund investors, under performing buy-and-hold hedge fund investors by about 4% a year. And those that switched among the funds with the highest returns trailed by about 9% per year.
Theses statistics prove what academic research has demonstrated:
As far as persistence, the average mutual fund unperformed its risk-adjusted benchmark by about 1.5% a year (pretax), the average hedge fund has provided risk-adjusted returns that have had a hard time keeping up with Treasury bills!
Delusion allows people to continue to be overconfident, which is a huge problem. Statman offered up this statistic: “Members of the American Association of Individual Investors overestimated their own investment returns by an average of 3.4%, and they overestimated their returns relative to the average investor by 5.1%.”
Because overconfidence could lead to unrealistic optimism, it causes investors to concentrate their portfolios in a handful of stocks rather than gain the benefits of diversification. The saying goes; there is no such thing as a free lunch, but portfolio diversification is the next best thing.
