STRINGER SHANGHAI
You'll never read in an analyst's report the most important part of investing: your human instincts.
Prudent decision making based on investment fundamentals can be easily undermined by fear, greed or a misunderstanding of risk. Investors can instantly improve performance by casting a critical eye on themselves, a part of investing called behavioural finance.
During the fall of 2008, when stock markets were collapsing, many investors exacerbated their problems because of fear. Pulling money out at the bottom and stuffing it in a savings account is a good example of myopic loss aversion. That's when investors are scared by short-term volatility, leading them to avoid risk and, as a result, to miss out on rebounds.
Proper asset allocation and risk assessment are key to investing. But so are behavioural traits that produce winning portfolios. Here are the most common mistakes investors make and how to avoid them.
Representativeness
Investors are quick to label a company's quarterly earnings as having beaten, trailed or met expectations. If a company beats analysts' estimates, more of the same is expected in the future. But many factors affect performance, which can be eroded by market changes or intense competition.
Product launches can send signals to investors that aren't necessarily indicative of future performance. Take Palm , for instance. When the company rolled out its new smart phones, the Pre and the Pixi, investors piled in on the strength of the operating system and the slickness of the device, assuming the products would be representative of the company's future prospects. But there were several large factors working against Palm.
Since last year, Palm's stock has fallen from a high of $18 (U.S.) to $3.77. The phones weren't the whole story, and many investors got burned. The balance sheet, threats from other devices and the subpar Sprint network were serious barriers.
Overconfidence
Many investors, even novices, hold their own opinions in high regard, which can lead to problems. Whether they know it or not, investors usually make a confidence interval in their head when determining prospects for an investment. This is basically a range of the expected return on an investment. If an investor expects a stock to return 10 per cent in a given year, he may be 95 per cent confident that the actual return will fall between 2 per cent and 20 per cent. Overconfidence leads to a range of values, an interval, that's too narrow. In reality, the interval that would capture the actual return with 95 per cent confidence would likely be much wider, with values ranging from -7 per cent to 25 per cent.
Overconfidence produces narrow confidence intervals, which lead to an underestimation of risk. This will result in more surprises. This behavioural problem means losses can be much bigger in magnitude than the investor originally expected. Since the risk was thought to be minimal from the original confidence interval, there's a much larger downside than the investor had anticipated, which can generate unpleasant outcomes.
Investors would do well to anticipate a greater distribution of possible returns, since more people underestimate risk.
Loss Aversion
No one likes to lose money, but many investors stick with an investment much longer than they ought to in the attempt to avoid losses. Investors are unlikely to think of a loss as a real thing until the stock has been sold and the loss realized, but this is, of course, ridiculous. In the worst-case scenario, this aversion may also lead to increased risk-taking as the investor doubles down in hopes that the gain will wipe out the loss.
This problem can be seen in investors who rabidly support stocks, like the community that has sprung up around Sirius XM . Becoming "married" to an investment is never a good idea. As satellite broadcaster Sirius fell from the high single digits to below $1 over the past few years, many investors lost a substantial amount of money. For an investor who had an average cost basis of $6 when the stock fell to $3, he lost half his money. If he had cut his loss and invested in a S&P 500 Index, he would have lost 55 per cent despite the incredible decline in the index at the end of 2008. By sticking with Sirius the entire time, the investor lost 85 per cent.
Accepting that an investment may have been a mistake and moving on to more fertile ground is nothing to be ashamed of. Professional investors do this constantly. Sirius may have an interesting product, but as we saw earlier with representativeness, one shining factor can't outweigh all the disadvantages.
Anchoring
The saying goes that you have only one chance to make a first impression, and that goes for investments as well. Many investors make judgments about investments and never change their mind.
Take Apple , for example. Many investors may think the company's fundamentals don't support the lofty stock price. But suppose iPad sales easily surpass every estimate. An investor suffering from anchoring will fail to fully incorporate the good news into their analysis due to their initial negative stance.
Much like overconfidence, this trait will lead to more surprises as performance results outpace expectations. Investors would do well to try to be as objective as possible when analyzing potential investments. If you begin with a dim view of Apple, it may be hard to see new positive information for its full value. Taking a consensus opinion from analysts covering a stock can help adjust expectations.
Fighting against your own human instincts is incredibly difficult, but it's necessary when making investment decisions. It may not feel good, but it's best for your portfolio. Besides, a little insight therapy never hurt anyone.