Whether it's the Dutch tulip craze of the 17th century, the dot-com mania of the late 1990s, the infrastructure craze before the GFC, or the latest post-pandemic bull run, there's no shortage of examples of investors behaving irrationally.
These emotion-driven bubbles constantly remind us that our human weaknesses limit our ability to think clearly. Investors are too willing to extrapolate recent trends far into the future, too confident in their abilities, and too quick (or not quick enough) to react to new information. These tendencies often lead investors to make decisions that run counter to their own best interests.
The biggest downside risk to the investor is themselves.
While high inflation, market crashes, and pandemics can all create short-term disruptions to the progress of your portfolio, permanent damage tends to occur when we make poor investment decisions. Such decisions tend to occur when we allow our emotions to govern our actions.
Overconfidence, optimism, and a belief that recent high returns can be replicated in the future. This can lead to investors over-paying for an asset and never achieving a return as optimism evaporates and the price reverts to a more realistic lower value.
Fear occurs when investors sell holdings following a crash. By doing so, they realize losses that would otherwise have been erased in a subsequent recovery.
Combatting these emotional pressures requires a strong investment process and the ability to think independently. Please read My biggest investment goof-ups.
Mistake 1: You are reading too much into the recent past.
When faced with lots of information, most people come up with easy rules of thumb to help them cope. While useful in some situations, these shortcuts can lead to biases that cause investors to make bad decisions. One example is "extrapolation bias," the overreliance on the past to assess the future.
Instead of doing all the necessary and possibly tedious homework in researching a potential investment, investors instead "anchor" their expectations for the future in the recent past.
The problem is that yesterday doesn't always tell you what tomorrow will bring. At the recent market crash, so many ended up suffering huge losses because the intrinsic value of the stock was never considered. It was just assumed that the good times would continue.
The past is no guarantee of future performance. Please read 4 strategies to combat market impulses.
Mistake 2: You think you are smarter than the rest.
In a 1981 study asking Swedish drivers to assess their own driving abilities, 90% rated themselves as above average. Statistically speaking, that's just not possible. But most of us are just like the Swedes: We think we're more capable and smarter than we really are.
As an investor, you should check your excessive optimism at the door. You might believe you're more likely than the next guy to spot the next multibagger, but the odds are you're not.
According to several studies, overconfident investors trade more rapidly because they think they know more than the person on the other side of the trade. And all that trading can be hazardous to your wealth, as University of California, Berkeley professors Brad Barber and Terrance Odean put it in their 2000 study of investor trading behavior.
The study looked at approximately 66,000 households using a discount broker between 1991 and 1996 and found that individuals who trade frequently (with monthly turnover above 8.8%) earned a net annualized return of 11.4% over that time, while inactive accounts netted 18.5%. Investors who traded most often paid the most in brokerage commissions, taking a huge bite out of returns.
All that trading might've been worthwhile if investors replaced the stocks they sold with something better. But interestingly, the study found that, excluding trading costs, newly acquired stocks actually slightly underperformed the stocks that were sold. That means that rapid traders' returns suffered whether or not fees were taken into account. Some researchers have come to a similar conclusion studying fund manager trading--standing pat is often the best strategy. Please read 4 questions to ask before you sell equity.
Mistake 3: You are more likely to sell your winners instead of your losers.
Investors in Odean and Barber's study were much more likely to sell winners than losers.
For one, investors would rather accept smaller but certain gains than take their chances to make more money. Secondly, investors are reluctant to admit defeat and sell stocks that are underwater in hopes of a rebound. As a result, investors tend to sell their winners too early and hang on to their losers for too long.
Instead, investors should practice averaging up. Averaging up will require you to move more money into stocks that are increasing in value. It appears counterintuitive, but in doing so, the winners get magnified. To anchor your buying decision to the price you paid for the stock is a defeatist strategy. Your buy decisions must be anchored to information about the company and its business. The price of the stock should enter the picture only after you have analysed the company behind the stock.
Please read How to average up on a stock.
You also shouldn't be afraid to sell a loser because it will turn a paper loss into a real one. Hanging on to a dog in hopes of breaking even is a bad idea because you may be forgoing a better opportunity. The trick is knowing when it's time to cut bait.
That's why it pays to have clear reasons in mind for your purchase of any investment right from the get-go. If your expectations don't pan out, then it's time to sell.
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