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(David Zalubowski)
(David Zalubowski)

Strategy

Bad habits sow bad investments Add to ...

Dan Richards is president of Strategic Imperatives. He is a faculty member in the MBA program at the Rotman School at the University of Toronto. He also hosts a weekly conference call called Monday Morning Jump Start, which is about strategies for financial advisors. Advisors can see it GlobeAdvisor.com. He can be reached at richards@getkeepclients.com

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Recently, a money manager I was talking to said his investing motto comes from the words of Polish composer Frédéric Chopin: "Simplicity is the final achievement. After one has played a vast quantity of notes and more notes, it is simplicity that emerges as the crowning achievement."

It's easy to make investing complicated. By contrast, Warren Buffett has said that all it takes to invest successfully is having a sound plan and sticking to it - and that it's the "sticking to it" part that investors struggle with the most.

To understand why this is, more and more economists and finance professors are studying the field of "behavioural finance," analyzing the patterns of things people do that end up costing investors money.

Someone who has written on this topic extensively is Lisa Kramer, a colleague at the University of Toronto's Rotman School of Management. In a recent telephone conversation from Stanford University, where she's doing research, she outlined some costly behaviours to which investors can fall victim.

Overconfidence

Ask an audience if their driving ability is above or below average. Typically, 95 per cent will say they're in the top 50 per cent. As a result, people believe that talking on a cellphone or texting while driving might be dangerous for others, but their own outstanding driving skills mean they can get away with it.

Research by Terrance Odean and Brad Barber of the University of California shows there is a natural tendency to overestimate investment knowledge as well, particularly among men.

Many do-it-yourself investors believe that by nimbly jumping in and out of stocks, they can beat the market. Messrs. Odean and Barber dug deep into the records of heavy traders at a discount brokerage firm. What they discovered was that there's an inverse correlation between the number of trades and investor returns: The more trading you do, the lower your chances of success. And even if investors do show a paper profit, often commission fees turn that into a loss.

Their conclusion: "Excessive trading is dangerous to your wealth."

Along the same lines, it's not uncommon to see corporate executives having the bulk of their net worth in the shares of their company and other companies in their industry. They believe their unique vantage point and knowledge give them an advantage - right to the point that their firm or the whole industry goes off a cliff.

Herding

A second trap is herding, also known as the lemming effect. It's hard to be standing on the sidelines while everyone around you is making money, or to be losing money in the market while others stand safely on the sidelines.

Classic examples include the U.S. housing market at its frothy peak and the Internet bubble in late 1999 and early 2000. We all hate to miss out - among Warren Buffett's claims to fame was his stolid resistance to investing in tech stocks during their mania.

At the height of the Internet frenzy, I interviewed one investor whose adviser had kept him out of the tech darlings. I vividly recall his words: "It's like there's this unbelievable party next door. There's music, dancing, great food, everyone's having a fantastic time - and I'm in my kitchen eating a salad."

It can be equally difficult to hang in during markets such as we've seen of late. "The buy part is easy," Ms. Kramer says. "It's the hold part in tough markets that's the challenge."

Anchoring and regret

There are many other behavioural traps that cost us money. Anchoring makes us fixate on the price we paid, regardless of whether that price is still relevant. We have a tendency to latch on to what we paid or what something was worth at its peak, even after the world has changed; some investors held Nortel all the way down, waiting for it to get back to $60 or $80.

When it comes to regret, research shows that investors experience more pain when they lose money than satisfaction when they make it; that's one of the drivers of risk aversion.

"That's why people hang on to investments that are underwater, avoiding the pain of selling them," Ms. Kramer says. "And then when they do finally sell, they often do it all at once to get it over with. On the other hand, research shows a tendency to sell winners over time, to savour the sense of accomplishment."

In a column earlier this spring, I talked about investors' emotional responses to market movements and the resulting tendency to buy at the top and sell at the bottom - and referred to Walt Kelly's famous line from his cartoon strip Pogo: "We have seen the enemy and he is us."

This line is equally true when it comes to behavioural finance traps. The good news is that awareness is the first step to change - and a growing understanding of the behaviours that undermine investment success means we are better positioned to avoid them going forward.

 

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