Every wealthy investor has skeletons in the closet: Stories about bad investment decisions they made, money they lost, opportunities they missed, market signals they ignored.
Often these skeletons can be traced back to emotional errors: illogical, emotion-driven thinking that supersedes rational investment analysis. Such errors can severely limit returns and prevent investors from reaching financial goals.
While I see these mistakes most often with the wealthy, there is nothing exclusive about them - emotional errors can (and do) afflict investors of all levels of wealth. Allow me to describe some of these mistakes, and provide some suggestions to help you avoid them.
Many wealthy investors overestimate their ability to understand the markets. Some believe they can predict market movements; others think they can beat the experts at stock picking. This can be an issue with wealthy business owners, who sometimes assume business success translates verbatim into investment success.
A young high-tech entrepreneur I met at a conference several years ago is a case in point. Back in 2000, he sold his software company for over $10-million. He subsequently made a substantial "angel" investment in a single dot-com startup. He was confident he had a good read on the company, its industry, and its management. Things did not work as planned, and he lost a good chunk of the wealth he had built.
Before you commit to any investment, make sure to conduct a thorough what-if analysis that posits a range of investment outcomes. Above all, keep a close eye on concentration risk: If you're looking to preserve capital and reduce risk, any single position should be no more than 10 per cent of the market value (not cost) of your portfolio. Beyond that, you should consider rebalancing or hedging.
Losing money is difficult for even the best investors. But some take it to another level, refusing to acknowledge that an investment hasn't worked out as planned. They hang on to "dead money" positions even when there is very little chance of recovery.
A colleague of mine told me a story about a wealthy client: a smart executive who was good at identifying business opportunities and challenges, and had no problem divesting businesses that weren't performing.
His personal portfolio was different. In it, the client hung on to positions years after they had dropped in value. The opportunity cost of these positions was staggering, yet the client refused to accept the loss.
Here's the bottom line: losses are not a defeat. There is nothing wrong with changing an investment decision if the economic climate or the business has changed. In our practice, we set a line in the sand: If an investment drops by 15 per cent of the initial investment amount, we re-evaluate our assumptions. If we still believe in the investment, we ask: "If we had a brand new dollar today, would we still buy this position?" If yes, we buy back in. If not, we move on.
Some people treat investing as a game. Instead of avoiding risk, they pursue it. The potential for loss generates excitement rather than anxiety. Yet these people still have normal financial goals: a secure retirement, sending kids to university, making charitable gifts, and so on. These goals are completely inconsistent with a high-risk approach.
Years ago, I had a wealthy client with a large portfolio heavily invested in venture market stocks: junior gold miners, oil and gas drillers, and the like. He was an active trader, often jumping in and out of positions several times a week. Most of these trades were losers. But one out of every dozen would work out, and give him the confidence he knew what he was doing. Eventually, I resigned the account. The client wasn't looking for a wealth manager - he was looking for a gambling buddy.
It's exciting when a high-risk investment makes money. But you need to limit the impact of such risk-taking on one's overall portfolio. If you want to speculate, divide your portfolio into two segments - "serious money" and "play money." The latter should be no more than 10 per cent of your liquid net worth. Anything above that you should take to the casino, because that's really what you're doing.
Mr. Stenner is director, wealth management, and founder of Stenner Investment Partners of Richardson GMP. He is managing director for TIGER 21 Canada and author of True Wealth.