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Avoiding ‘hindsight bias’ and other investing pitfalls

Gina Macdonald finished a degree in psychology before pursuing a career as a fee-only financial adviser and portfolio manager. That social-sciences background has proved useful: Ms. Macdonald often finds herself helping clients manage their emotions as much as their portfolio holdings.

Among the "cognitive errors" she encounters are overconfidence and hindsight bias, which can make an investor believe that a past event was more predictable than it actually was. Another is regret avoidance – where investors refuse to admit to themselves that they've made a poor investment choice so they don't have to deal with the unsettling emotions that the decision brings up.

All can affect an investor's success.

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"When I first started in this field, a lot of people thought psychology had nothing to do with financial planning," says Ms. Macdonald, who is a principal at Vancouver's Macdonald Shymko and Co. Ltd. "Now people have become more evolved and know that money has a lot of psychology to it.

"It's like religion or sex: Money is a hot button," adds Ms. Macdonald. "Money is a big thing in a relationship. Nobody's spending habits or savings philosophies are necessarily perfectly aligned."

That may be true for couples, but when it comes to an adviser-client relationship, the two parties' investing philosophies need to be in sync, Ms. Macdonald says.

Her firm's approach is not for those who like to speculate on the direction or timing of the market.

"We're asset class investors, not stock pickers," say Ms. Macdonald, a mother of four who's been in the industry for 20 years. "No one has a crystal ball, despite the fact that many people try to convince you that they do. ... If you're looking at things like sector rotation, that's stock picking or active management or crystal-ball gazing, and we don't do that.

"You have to make two good decisions: You have to know when to go in and – the harder question – when to get out," she adds. "You have to have two perfect decisions, and you may do that once or twice, but on an ongoing, consistent basis over a long time period, you're not doing it – otherwise you're just throwing darts at a board, statistically."

Macdonald Shymko describes asset allocation as a systematic and structured approach to creating an appropriate investment mix. That mix is based on a client's goals and risk tolerance, not on market timing.

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"We're trying to diversify to optimize investments and reduce risk," Ms. Macdonald says. "We look at risk profile and retirement-income needs to come up with an appropriate asset allocation between fixed income, equities and real estate investments. Then we primarily use ETFs [exchange-traded funds] and alternative investments, such as mortgage investments and flow-through investments, to meet those goals."

Although ETFs have become an increasingly popular vehicle, Macdonald Shymko has been recommending them since the 1990s. Ms. Macdonald favours them because they have lower management expense ratios (MERs) and because they allow for diversification by capturing the breadth of the market.

ETFs typically incur fewer administrative costs than actively managed portfolios. They offer tax efficiency as well: Fewer trades mean fewer taxable distributions.

Ms. Macdonald notes that even with their advantages, careful selection of ETFs is crucial.

"People have caught on the buzzword of ETFs and they want them, but they seem to be focused on the fee and not necessarily the investment or what they represent," she says. "All of the fund companies are coming out with ETF-type portfolios, or active ETFs; it's just a mishmash out there.

"So you still have to drill down and investigate what you're buying. Just because it says ETF at the end of it doesn't mean it's the best investment for you."

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Geographical diversification is another important element of Ms. Macdonald's investing style.

"A lot of people just focus on Canadian investments," she says. "Canada is only 3 per cent of the global market, yet a lot of people have a home bias of just investing in Canada; it's comfortable. But you need to look at the global economy to help diversify yourself. If our dollar dropped 20 per cent in the last year, well, if you held U.S. securities in your portfolio, that would have been a 20-per-cent lift right there."

Ms. Macdonald makes it clear, too, that her approach to money management is not limited to investments.

"Sometimes, when people first come in, they just want answers about their investments, but you need to look at your big picture first," she says. "You need to step back and have the reflection process about what your short-term and long-term goals are."

She looks at "how your assets and liabilities are structured between spouses and for tax efficiency; we look at isolating a savings capacity and productively applying it [savings] toward a goal. There may be insurance needs; maybe people are overinsured.

"Investments are a tool to reach your goals," she adds. "My clients recognize that investments are part or your financial plan but are not your only financial plan."

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