All change: when a new broom means investors can reap the rewards
A change of senior management at a company can either be a blessing or a curse for investors. While...
We all like to think we are considered, balanced and rational investors. In reality, though, most of us fall into at least a few common traps.
Behavioural finance explores these mistakes we seem to make again and again. It traces human traits back to instincts developed thousands of years ago and looks at how they affect the psychology of our investing (and other financial decision making) today.
Here are six common investing mistakes and some tips to help you avoid them.
Otherwise known as anchoring, this is when we fixate on one piece of information to the detriment of others. A good example is the so-called ‘Santa rally’, which proposes that markets generally trend up towards Christmas as people are in better moods and more positive.
The danger is, we end up sleep-walking into potential losses. Looking at the Santa example, had you invested at the beginning of December in 2016 and 2017 expecting a rally, you would have been rewarded with gains of 3% – 4%*. However, had you done the same in 2015 or 2014, you would have made losses of up to 2%*.
Remind yourself to look at a broad range of consistent fundamentals before making any investment decision.
Or, herding. This is when investors ‘follow the crowd’ and choose a particular investment because everyone else seems to be doing so. It plays on our instinctive ‘safety in numbers’ assumption – if other people are buying, it must be a good investment.
However, herd buying can over-inflate prices and create bubbles, which is bad news for investors when they eventually burst.
Again, try to look at the fundamentals of an investment and use your own analysis rather than the consensus of the market. You also need to think about whether the investment suits your personal goals and risk profile.
This leads to confirmation bias. Basically, this is when we hear a ‘hot tip’ from a friend, or perhaps see good one-year return figures, or even just like the branding of a particular fund – and we make up our minds straight away that it is a good investment.
Later, when we ‘research’, we then filter information selectively to back up our opinion. In this way, investors often overlook facts and crucial details that could significantly affect their returns.
Each time you consider an investment, be prepared to critique and question it, not just confirm your preconceptions. Also, be conscious of what drove past performance. A fund may have had a stellar period, but driven by tailwinds of a good economy or currency strength, rather than manager skill. Similarly, a fund may have had a good period but the manager has since changed.
A well-known investment adage is ‘buy low, sell high’. In reality, though, it is all too common to see investors pulling their money out of funds when markets go down sharply.
It’s understandable, as these are often important savings and it’s hard to watch their value decline. But it’s also a common overreaction.
Overreaction and availability is when investors treat new news with more weight than older news. Knee-jerk reactions (e.g. sell everything! markets have fallen 20%!) can lock-in losses that otherwise could have been avoided and lead to severe regret down the track.
Thinking long-term and avoiding day-to-day market noise is key. A good way of protecting yourself from this tendency is to consider different scenarios of what could happen before you invest, and be braced for volatility and some periods of loss over the life of your investment.
Referred to as prospect theory. Discounting market noise takes a lot of discipline and isn’t helped by the fact investors typically fear losses more than they value gains.
Let’s look at an example of two funds over two weeks:
Both have the same outcome, but it would be common for investors in fund A to feel like they had ‘lost out’ because they lost some money from the fund’s peak.
On the other hand, investors in fund B would typically be happier with their results and more likely to hang on to the fund, as their returns have steadily risen.
Again the lesson is to think long-term and avoid reacting to short-term sentiment. It’s also important to keep in mind broader market movements. The market might have posted large falls over the period, and in fact your fund may have performed better than its peers.
What doesn’t help with the previous situation is how we typically respond afterward. In the case of fund A, for example, a few weeks on investors often start to say that they knew they drop was coming and kick themselves for not selling sooner.
In reality, they may have had a vague thought their investment could potentially fall, but if they were convinced by that, they would have sold.
When we look back, we typically remember only the thoughts that were prophetic and not the incorrect ones.
The problem is, this leads to investors starting to ‘believe their own hype’ and trading on hunches because they have had some correct thoughts in the past. They also tend to rush a subsequent decision without fully researching because they feel they missed out before and they don’t want to do that again.
As I’ve mentioned, it’s important to always do considerable, fundamental research when making an investment decision. Another idea is to record all your thoughts in a kind of ‘investment journal’, so you can look back honestly and assess what would have happened in each situation had you simply acted on your whims.
*Source: FE Analytics, FTSE All Share total returns in sterling from 1 December to the last trading day before Christmas each year
NB: This article was first published in February 2016 and edited for republication in December 2017.