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I find the start of the new year to be magical. The meter gets set back to zero and provides an opportunity for a do-over. For many, that do-over often includes becoming healthier or getting on top of your finances.
So how do you achieve your do-over goals? One key step is to recognize the danger of living on automatic. Consider that the average person makes almost 35,000 decisions a day. Many of those decisions we don't think about – like putting on our seatbelt when we get into the car. This is our brain's way of freeing itself to deal with more complex issues. However, many of us fall into the trap of going on automatic for more important decisions.
In his book The Power of Habit, Charles Duhigg identifies a three-stage loop or pattern that your brain falls into – (i) a cue which triggers (ii) a routine that generates (iii) a reward. This cycle gets imprinted into your brain and becomes habit. To change the habit, Duhigg suggests, you need to reprogram the routine that the cue triggers. The key first step is to understand what the cues are for your habit. So if you like to snack while you watch TV, the cue might be the TV, the routine might be eating a whole bag of chips, and the reward might be the pleasing crunch and salty taste. Changing that habit requires substituting the unhealthy routine (chips) for a more healthy routine (carrot sticks and celery).
The reward, or incentive, that follows the routine is important because it helps us address a key failing of human beings: we are very short-termed in focus. In other words, we "prefer the gratification of a slice of cake today rather than a carrot tomorrow." One way to successfully imprint the new habit is to identify a reward or incentive that will offset the current reward associated with the habit you want to change.
Similar behavioural loops occur in investing. News about a particular stock can trigger a habit of buying or selling that stock (depending on whether the news was good or bad, of course). A 2008 review of investor trading data by Barber and Odean supports the view that individual investors traded on news while institutional investors typically did not. In an earlier paper, those researchers found that active traders underperformed the market by 6.5 per cent annually.
You can easily substitute a different routine for your reactionary, news-driven trading habit. Go back and look at your investment goals and policy statement that you set up at the outset. Remind yourself as to what you are investing for and why. As Barber and Odean conclude, the news-driven trading "patterns we document here do not generate superior returns. We believe that most investors will benefit from a strategy of buying and holding a well-diversified portfolio. Investors who insist on hunting for the next brilliant stock would be well advised to remember what California prospectors discovered ages ago: All that glitters is not gold."
Sam Sivarajan is managing director and head of investments with Manulife Private Wealth.