Our brains were built to save us from ourselves. We misremember the past and pretend we can predict the future. We’re able to make sense of things when there is no sense to be made. Here’s an example- I was staying at a hotel a few weeks ago in San Diego and I walked into the shop to get some sunscreen. I was going to speak onstage the next day and I burn faster than most people.
Yea I spent twenty bucks, but how much would it cost somewhere else, $7 or $8? So what did I really waste, $12 or something? Not so terrible. Also, how much would I pay to not have a burnt head? At least $100. Wait a minute. They undercharged me by like eighty bucks, I robbed those suckers blind!
This is only a slight exaggeration; but the point is I was able to rationalize my absurd purchase in well under ten minutes.
Here’s another example of something that logic can’t defend but our brains easily do anyway.
You’re at a bar with five of your buddies and somebody steps up and picks up the bill, it’s $70. Your friend pulls out a credit card and nobody thinks anything of it. But what if he or she pulled out $70 in cash? Might you have the inclination to reach for your wallet? $70 is $70 whether it’s paid with paper or credit, but I imagine those two scenarios would leave your five friends feeling quite different.
We’ve all read the behavioral finance books. We all know that our brain plays tricks on us and that our heart sabotages our brain.
So what can we do about it? How do we avoid the same mistakes that investors have been making since the beginning of time? If I had the answer I would, well, I don’t have the answer, but here are a few ideas.
If you’re making a decision about the future, which is by definition unknown, go with regret minimization. You have a stock that’s gained 100%, but it’s hard to sell because what if it gains another 100%? But at the same time, what if you get greedy and and give back all your gains? Tough situation. Here’s how I would think about it: What would feel worse? If you sell it now and it doubles, or if you hold onto it and give back all your gains? You’re not going to sell it at the top, so make a decision with the information you have and then live with it. But it’s never that easy, because whatever you decide this time will affect your decisions next time. For example, you sell now and it doubles again, what do you think you’re doing next time? You’re going to hold on because you remember that painful experience. Try as hard as you can to not allow the past to poison your future.
Here’s another idea- If you’re about to buy a stock, have a plan before you buy it. For example, you buy at 70, you’re out of a quarter at 80, another quarter at 90, etc. Same thing if it goes in reverse. A trailing stop, or predetermined exits might not be optimal, but who runs an optimal portfolio? It’s about getting better, not getting it best.
If you’re not trading stocks and instead hold a diversified portfolio, know ahead of time when you’re going to rebalance. Put it on the calendar! Also, decide how far you’re willing to let your target allocations drift before you bring it back into balance. I’ve never met an investor who consistently makes the right choice in the heat of the moment so having these things written down can save you a lot of trouble and money
Just knowing that we have biases is not enough to stop them, you have to actually take proactive steps before you pay twenty dollars for a tube of sunscreen.
The original article is authored by Michael Batnick, CFA and is available here.
- A death cross is a technical indicator that occurs when the short-term moving average of a security such as a stock falls below its long-term moving average.
- The onset on a death cross can signal a bear market is on the horizon.
- Investors can utilise death crosses to help identify low-price entry points into the market.
In a 2000 article published in Money, Jason Jweig profiled a remarkable investor and friend of Warren Buffett named Joseph Rosenfeld who oversaw the investment committee for Grinnel College, a small school in Iowa.
“Joe,” says Buffett, “is a triumph of rationality over convention.” By ignoring the conventional wisdom about investing, Rosenfield has made money grow faster and longer than almost anyone else alive. Since 1968, he’s turned $11 million into more than $1 billion. He has heaped up those gains not with hundreds of rapid-fire trades but by buying and holding–often for decades. In 30 years, he’s made fewer than a half-dozen major investments and has sold even more rarely. [emphasis added] “If you like a stock,” says Rosenfield, “you’ve got to be prepared to hold it and do nothing.”
Here are the lessons from Joe Rosenfeld as summarized by Jason Jweig.
Do a few things well. Rosenfield built a billion-dollar portfolio not by putting a little bit of money into everything that looked good but by putting lots of money into a few things that looked great. Likewise, if you find a few investments you understand truly well, buy them by the bucketful. However, I think Rosenfield is a rare exception. Without his kind superior knowledge, skill and connections, most of us mere mortals need to diversify broadly across cash, bonds, and U.S. and foreign stocks.
Sit still. If you find investments that you clearly understand, hold on. Since it was their long-term potential that made you buy them in the first place, you should never let a short-term disappointment spook you into selling. Patience–measured not just in years but in decades–is an investor’s single most powerful weapon. Witness Rosenfield’s fortitude: In 1990, right after he bought Freddie Mac, the stock dropped 27%-. Rosenfield never panicked. Instead, he just waited. “Joe invests without emotion,” says Buffett, “and with analysis.
Invest for a reason. Rosenfield is a living reminder that wealth is a means to an end, not an end in itself. His only child died in 1962, and his wife died in 1977. He has given much of his life and all of his fortune to Grinnell College. “I just wanted to do some good with the money,” he says. That’s a lesson for all of us. Instead of blindly striving to make our money grow–or measuring our worth by our possessions–each of us should pause and ask: What good is my money if I never do some good with it? Is there a way to make my wealth live on and do honor to my name?
The original article is authored by Greg Speicher and appears on the blog here.
When it comes to gauging the worthiness of an investment, investors often land way off the mark. Most treat short-term returns as a yardstick, while others have unrealistic expectations. Yet others misinterpret returns completely. However, correct assessment of performance is a must to avoid bad investment decisions.
For most investors, point-to-point return figures serve as the performance yardstick. This can be misleading. The current return profile of equity funds, for instance, is a case in point. The three-year returns of most equity funds comfortably outshine the five-year figures (see chart). Large-cap funds have clocked 13.5% CAGR over the past five years compared to 17.8% over the past three. Mid-cap equity funds have yielded 20.6% CAGR over the past five years against a whopping 34% in three years. To the lay investor, this sharp disparity in returns poses a dilemma—if the return is so much higher for a three-year period, does it make sense to stay invested for five years or more? But the investor is overlooking two critical elements here. First, he is considering a singular point-to-point reference from the past to make an assumption about the future. Second, he is ignoring the difference between annualised returns and simple absolute returns.
Let me assure you – No matter how positive (or negative) you are about something, there will always be much which will not be in your control.
There are things you cannot change and things that are totally in your control. The hard task is to understand the difference between the two.
When I started writing this post, the idea was to list in order of importance, habits which set apart successful investors from those who achieve substandard returns. Naturally, such a list would require me to first state who would qualify as a ‘successful investor’ and what’s ‘substandard’.
Meeting with individual investors over the years has taught me much about investing mistakes. No matter how you classify investors (i.e. fundamental, technical or confused), the mistakes they make are almost invariably identical.
While some mistakes are the result of simply not knowing what to do, many are the results of either (i) losing interest; or (ii) getting overly greedy or fearful, particularly when the tide turns. In either case, much money is lost when people assume things will simply take care of themselves.