Psychologists have known for a long time that people often act in a seemingly irrational manner and make predictable errors when forecasting. This behavior is harmless when it causes a zest for the home sports team. Being overly optimistic when rooting for your team is fun. However, when this behavior affects your investing decisions, it can cause you to make small mistakes that lower your return or make big blunders that devastate your wealth.
All people are affected by psychological biases. However, traditional finance considers this irrelevant. Traditional finance assumes that people are "rational." Financial theory has developed with the proposition, called market efficiency, that stock prices are reasonably accurate and reflect the true value of firms. If stock prices are efficient, then investors won't do serious harm to their wealth if they trade frequently or follow specific investing strategies. Therefore, financial economics has developed in a proscriptive manner. That is, it has developed ideas and useful financial tools for how investors should behave. As a consequence, little research has been conducted on actual investor behavior.
Alternatively, behavioral finance examines how people actually behave in a financial setting. Specifically, it is the study of how psychology and emotions affect financial decisions and financial markets. If the psychology of investors, as a group, is strong enough, it may affect the accuracy of stock prices. Indeed, stock market manias and bubbles may result. Additionally, by allowing psychological bias and emotion to affect their investment decisions, investors can do serious harm to their wealth.
Behavioral finance is a relatively new field and is developing rapidly. In my book Investment Madness, I documented many of the known problems with letting psychological biases invade the decision-making process. As more scholars and investment professionals have become interested in behavioral finance, the theories have evolved and evidence for their validity has expanded. In this chapter, I review many of these psychological biases and emotions that cause investors to make mistakes. The problems are illustrated here with new evidence and recent examples.
I organize these investment problems into three categories: psychological biases, emotions, and simplification. Specific problems within each category are detailed in the following three sections.
Thanks Darren Winters
Thursday, 28 June 2007
Self-Inflicted Common Problems - Darren Winters
Much of the harm that occurs to an investor's wealth is self-inflicted. The ways people think about investing often leads them into mental traps and false beliefs. In most cases these problems cause minor setbacks that can be chalked up to a "lesson learned." However, if the lessons aren't learned, then a major investment blunder can occur. It only takes one major blunder to severely affect your wealth and your retirement lifestyle.
Many of these problems come from the human decision-making process. Investors tend to let their emotions interfere with their good judgment. The way in which the brain functions also biases investor beliefs. Consider that employees frequently think that the stock of the company they work for is a safer investment than a diversified portfolio of S&P 500 firms. Their familiarity with their employer tricks them into miss-understanding the true risks involved. The sad plight of the Enron employees illustrates the point. However, employees in many other firms, like Lucent Technologies, are feeling this same pain.
Darren Winters
The brain tricks investors in many ways. For example, people see patterns in data that is completely random. Because of the vast amount of information and computing power available, many investors are able to conduct sophisticated mining operations of the data. As a result, they think they find patterns that will make them big profits in the future. Convoluted and nonsensical strategies, like the Foolish Four strategy previously touted by The Motley Fool, are then created and implemented. After all this effort, investors later realize that the strategy doesn't work. What went wrong?
Sometimes we decide to take the recommendations of the experts. Who are the experts? Is their advice any good? There are significant problems with the recommendations of analysts, economists, investment newsletter writers, Value Line, and even the corporate insiders. The following five chapters explore these issues.
Kind Regards Darren Winters
Many of these problems come from the human decision-making process. Investors tend to let their emotions interfere with their good judgment. The way in which the brain functions also biases investor beliefs. Consider that employees frequently think that the stock of the company they work for is a safer investment than a diversified portfolio of S&P 500 firms. Their familiarity with their employer tricks them into miss-understanding the true risks involved. The sad plight of the Enron employees illustrates the point. However, employees in many other firms, like Lucent Technologies, are feeling this same pain.
Darren Winters
The brain tricks investors in many ways. For example, people see patterns in data that is completely random. Because of the vast amount of information and computing power available, many investors are able to conduct sophisticated mining operations of the data. As a result, they think they find patterns that will make them big profits in the future. Convoluted and nonsensical strategies, like the Foolish Four strategy previously touted by The Motley Fool, are then created and implemented. After all this effort, investors later realize that the strategy doesn't work. What went wrong?
Sometimes we decide to take the recommendations of the experts. Who are the experts? Is their advice any good? There are significant problems with the recommendations of analysts, economists, investment newsletter writers, Value Line, and even the corporate insiders. The following five chapters explore these issues.
Kind Regards Darren Winters
Darren Winters - Extra
Unfortunately, our psychological biases and emotions are magnified when we try to outperform everyone else. We take foolish risks. The more successful we are in the beginning, the more risks we end up taking. Eventually, these risks come back to harm our wealth in the form of an investment blunder. Sooner or later, those investors going for broke end up getting there—broke. It is better to learn this lesson early. For example, consider the case of the early lesson. Here, the investor has some success beating the market and earning the 14% return. However, in year 5, a blunder occurs that wipes out 50% of the portfolio. At this point, the investor learns the lessons and just earns the market return for the remaining 15 years. This investor would have $612,000 at the end of the 20 years. Note that this is only half of the wealth dreamed about and two-thirds of the wealth that could have been acquired if the goal was to earn the market return all along.
The investor who learns the lesson midway through the time period is the mid lesson investor in the graph. This person has 10 years of success beating the market. He or she gets overconfident and starts taking more risk. In year 10, the investor experiences the blunder that decreases the portfolio by 60%. Note that the blunder loss is greater than that of the early lesson investor. This is because a longer period of success leads to greater risk taking and thus a higher potential for losses. After learning the lesson, the mid lesson investor ends up with $491,000. The late lesson investor experiences a 70% loss in the 15th year and ends the period with $373,000.
I should also note that many investors try to beat the market but never do. They chase last year's mutual fund winners. They try to time the market by jumping in and out of the stock market and specific stocks. They follow the advice of investment newsletters, analysts, and other gurus. The worst thing that many investors experience is that they always seem to underperform the market. That is, many investors don't experience one large investment blunder; instead, they experience many tiny ones. The investor that fails to earn the market return may earn only 10% per year. This active investor is also shown in the figure. Interestingly, experiencing yearly tiny blunders is better than experiencing one great blunder. The active investor ends the period with $680,000.
It may be that some investors can beat the market on a continuous basis and never experience a blunder. According to the figure, they would be greatly rewarded. The problem is that very few investors can do this. Some of those who do so are just plain lucky, not good. Ultimately, the pursuit of beating the market leads to investment blunders that seriously harm your wealth. Trying to seek the highest returns is dangerous business.
Consider the analogy of investors as members of Alcoholics Anonymous (AA). Out of 20 alcoholics, one may be able to eventually learn to be a social drinker again without becoming addicted again. If you were to tell the 20 members of AA this, each would likely think that he or she is the one who can do it and would give it a try. Our psychological biases make us overconfident and optimistic. As a consequence, most would try, and all those who tried (except one) would end up returning to their old habits. It would be better for the members to not try to become social drinkers. In investing, very few people can consistently beat the market. However, most of us believe that we are the one who can do it. In the attempt to outperform the market and our peers, we make foolish choices that open the door for an investment blunder. It only takes one blunder during your lifetime to seriously affect your wealth and your standard of living.
Thanks Darren Winters From Win Investing
The investor who learns the lesson midway through the time period is the mid lesson investor in the graph. This person has 10 years of success beating the market. He or she gets overconfident and starts taking more risk. In year 10, the investor experiences the blunder that decreases the portfolio by 60%. Note that the blunder loss is greater than that of the early lesson investor. This is because a longer period of success leads to greater risk taking and thus a higher potential for losses. After learning the lesson, the mid lesson investor ends up with $491,000. The late lesson investor experiences a 70% loss in the 15th year and ends the period with $373,000.
I should also note that many investors try to beat the market but never do. They chase last year's mutual fund winners. They try to time the market by jumping in and out of the stock market and specific stocks. They follow the advice of investment newsletters, analysts, and other gurus. The worst thing that many investors experience is that they always seem to underperform the market. That is, many investors don't experience one large investment blunder; instead, they experience many tiny ones. The investor that fails to earn the market return may earn only 10% per year. This active investor is also shown in the figure. Interestingly, experiencing yearly tiny blunders is better than experiencing one great blunder. The active investor ends the period with $680,000.
It may be that some investors can beat the market on a continuous basis and never experience a blunder. According to the figure, they would be greatly rewarded. The problem is that very few investors can do this. Some of those who do so are just plain lucky, not good. Ultimately, the pursuit of beating the market leads to investment blunders that seriously harm your wealth. Trying to seek the highest returns is dangerous business.
Consider the analogy of investors as members of Alcoholics Anonymous (AA). Out of 20 alcoholics, one may be able to eventually learn to be a social drinker again without becoming addicted again. If you were to tell the 20 members of AA this, each would likely think that he or she is the one who can do it and would give it a try. Our psychological biases make us overconfident and optimistic. As a consequence, most would try, and all those who tried (except one) would end up returning to their old habits. It would be better for the members to not try to become social drinkers. In investing, very few people can consistently beat the market. However, most of us believe that we are the one who can do it. In the attempt to outperform the market and our peers, we make foolish choices that open the door for an investment blunder. It only takes one blunder during your lifetime to seriously affect your wealth and your standard of living.
Thanks Darren Winters From Win Investing
Darren Winters - Effect of a Blunder
Experiencing an investment blunder can devastate your wealth. When you push too hard for top performance, you open the door for the possibility of a blunder. Investors who push too hard end up getting too aggressive and taking too much risk. Ultimately, the consequence of taking too much risk is to experience a problem that devastates your portfolio. You can easily lose 50%, 60%, even 90% of your portfolio. This book is full of examples of both professional and individual investors experiencing this exact problem.
A typical scenario is that an investor has a strong desire to outperform his or her colleagues, neighbors, the pros, and the market. In the pursuit of these riches, he or she falls into a psychological or emotional trap and loses a good deal of wealth. shows the experiences of many investors. First, let us assume that your household has a portfolio of $50,000 (including retirement plans) and can contribute to it at a pace of $6,000 per year for the next 20 years. The market earns 12% per year. You can earn the market return by indexing, a strategy Or you can try to beat the market and earn 14% per year. shows the building of wealth for the market and for our dream of beating the market. If you earn the market return, you will end up with $915,000. If you beat the market by 2% per year, then you will have $1,233,000 at the end of 20 years. The difference is substantial. Our greed and our overconfidence tell us to go for the 14% return.
Thanks Darren Winters
A typical scenario is that an investor has a strong desire to outperform his or her colleagues, neighbors, the pros, and the market. In the pursuit of these riches, he or she falls into a psychological or emotional trap and loses a good deal of wealth. shows the experiences of many investors. First, let us assume that your household has a portfolio of $50,000 (including retirement plans) and can contribute to it at a pace of $6,000 per year for the next 20 years. The market earns 12% per year. You can earn the market return by indexing, a strategy Or you can try to beat the market and earn 14% per year. shows the building of wealth for the market and for our dream of beating the market. If you earn the market return, you will end up with $915,000. If you beat the market by 2% per year, then you will have $1,233,000 at the end of 20 years. The difference is substantial. Our greed and our overconfidence tell us to go for the 14% return.
Thanks Darren Winters
Investor Performance - Darren Winters
The willy-nilly approach of most investors gives them a lack of solid foundation from which to make decisions. As a result, investor allocations and stock picks are frequently not aligned with their goals. One consequence is that the typical investor spends time moving money from one investment to another, trying to meet an obscure goal. Investing without a plan, or road map, leads to a lack of discipline. The lack of discipline allows your psychological biases and emotions to invade the process.
Ultimately, these problems cause many people to be poor investors. Indeed, investors who must make their own decisions underperform the market indexes. Consider the performance of 66,465 households that owned stock through a discount broker from 1991 to 1996. The average household in this sample owned just 4.3 stocks worth a total of $47,334. The first problem we can identify is that investors do not adequately diversify. Owning only four stocks? Having such a concentrated portfolio is very risky, "Foolish Risks."
What was the performance of these investors? First, the investors tended to pick riskier stocks. Specifically, they preferred the stocks of smaller companies. On average, the higher risk was rewarded with an average gross annual return of 18.7% compared to the market index of 17.9%. However, the average investor also turned over 75% of his or her stocks per year. That is, the average portfolio experienced the sale of three-quarters of its stocks to fund the purchase of other stocks. Due to the cost of trading, the net annual performance of the investors was only 16.4%. Individual investors underperformed the market by 1.5% per year. The more active the investor, the worse the net return. For example, the 20% of the investors that did the most trading underperformed the market by 4.8%. This compares to a return that beat the market by 0.6% per year for the 20% of investors that did the least amount of trading. Some of the underperformance of the active traders is due to transaction costs and some is caused by making bad choices. Active trading magnifies your emotions and psychological biases that cause these bad choices.
Also, the investors with the largest stock portfolios performed poorly. The 20% of investors owning the portfolios with the largest stock value had, on average, $149,710 in stocks. These investors underperformed the market by 1.7% per year. Who are these investors with the larger portfolios and the more active trading? It seems that a larger portfolio and a higher degree of trading would be associated with more experienced investors. If true, this is a frightening thought. That is, people may actually get worse as investors as they gain more experience. This phenomenon can be caused by the psychological biases, like overconfidence, "Behavioral Finance."
Of course, this study examined the average investor portfolio. Some investors experience something much worse than poor returns. Some investors, like Irv and Louise Trockman, experience an investment blunder that sets their wealth back many years.
Thanks Darren Winters Of Win Investing
Ultimately, these problems cause many people to be poor investors. Indeed, investors who must make their own decisions underperform the market indexes. Consider the performance of 66,465 households that owned stock through a discount broker from 1991 to 1996. The average household in this sample owned just 4.3 stocks worth a total of $47,334. The first problem we can identify is that investors do not adequately diversify. Owning only four stocks? Having such a concentrated portfolio is very risky, "Foolish Risks."
What was the performance of these investors? First, the investors tended to pick riskier stocks. Specifically, they preferred the stocks of smaller companies. On average, the higher risk was rewarded with an average gross annual return of 18.7% compared to the market index of 17.9%. However, the average investor also turned over 75% of his or her stocks per year. That is, the average portfolio experienced the sale of three-quarters of its stocks to fund the purchase of other stocks. Due to the cost of trading, the net annual performance of the investors was only 16.4%. Individual investors underperformed the market by 1.5% per year. The more active the investor, the worse the net return. For example, the 20% of the investors that did the most trading underperformed the market by 4.8%. This compares to a return that beat the market by 0.6% per year for the 20% of investors that did the least amount of trading. Some of the underperformance of the active traders is due to transaction costs and some is caused by making bad choices. Active trading magnifies your emotions and psychological biases that cause these bad choices.
Also, the investors with the largest stock portfolios performed poorly. The 20% of investors owning the portfolios with the largest stock value had, on average, $149,710 in stocks. These investors underperformed the market by 1.7% per year. Who are these investors with the larger portfolios and the more active trading? It seems that a larger portfolio and a higher degree of trading would be associated with more experienced investors. If true, this is a frightening thought. That is, people may actually get worse as investors as they gain more experience. This phenomenon can be caused by the psychological biases, like overconfidence, "Behavioral Finance."
Of course, this study examined the average investor portfolio. Some investors experience something much worse than poor returns. Some investors, like Irv and Louise Trockman, experience an investment blunder that sets their wealth back many years.
Thanks Darren Winters Of Win Investing
Other People's Problems - Darren Winters
Learn from the folly of others.
We can learn a lot from the mistakes of other investors because most mistakes are caused by human nature. We all experience the same psychological biases and emotions. Therefore, we are all susceptible to making the same mistakes. Some of these mistakes can have a large impact on our wealth.
Consider Irv and Louise Trockman, two retirees in Dallas. With the help of an overzealous broker, they managed to turn their $1.3 million nest egg into just $700,000. Imagine a loss of 46% of your retirement money. People in their 20s or 30s could recover some of the money before retirement, but Irv and Louise are already in retirement! Their standard of living will be dramatically affected. Irv and Louise made common mistakes. First, they got caught up in the overexuberance of the times and selected a poor asset allocation. Specifically, they were far too overweighted in stocks. Second, they picked risky tech stocks. They complicated the matter by borrowing money, called leverage, and investing that borrowed money. In short, they were tricked into thinking that their investments were much safer than they really were. They were tricked by their own minds.
The Trockmans were taking a lot of risk. Their broker should have warned them about the problem. Unfortunately for the Trockmans, their broker was more of a cheerleader than an advisor. Many investors believe their losses are due to poor advice from their brokers—which sometimes leads to arbitration. Over 6,000 cases of arbitration between investors and brokerage firms occurred in 2001. The need for arbitration can often be avoided when people fully understand the risks of investing and how to properly manage those risks. This book explains how people are often tricked by their own minds into believing their level of risk is low.
The advice we get from the professionals is not always that good. This is often due to the structure of the financial industry. The Trockmans' broker may not have discouraged their investment style because it made the broker money in commissions and fees. Indeed, we have been hearing strange investment advice for a decade. Through investment seminars and infomercials (and even some movies!), we have been conditioned to think that we can get rich by using other people's money. We are told that we should buy real estate with no money down. It is suggested that we should use the broker's money for our investments. What we haven't been told is that using other people's money is very risky! When you borrow money to invest, you are increasing your risk. Borrowing the maximum that is allowed from your broker will double your risk. Why aren't investors told this? Because the incentives of the financial industry do not always favor the individual investor. This book will help you to understand the investment industry and your own investment needs and behaviors. Hopefully, you will be able to avoid an investment blunder (or another one) like the one that befell Irv and Louise. Now, more than ever, your wealth is affected by your decisions.
Do-It-Yourself Investing - Win Investing
There is a worldwide trend toward investment autonomy. That is, people are being asked to manage their own money. Consider the trends over the past couple of decades in the pension arena. Employee retirement plans have gone from predominately managed by professionals in the defined benefit plans to predominately managed by the employee in the defined contribution plan—known as the 401(k) plan. In the late 1990s and early 2000s, serious debates occurred over the possibility of allowing Americans to manage their own social security investment money. Social security reform may yet include some type of self-directed account. Another example is the incredible amount of wealth transferred in the mid to late 1990s from full-advice brokerage firms to no-advice online brokerage firms. Investors have to make their own decisions.
In 1990, employees frequently had few choices in their 401(k) retirement plan. Options commonly were only a money market fund, a bond fund, a stock fund, and the company's own stock. Now participants are faced with allocating retirement assets over an average 11 different choices. Some plans have hundreds of mutual funds to pick from, or even the ability to buy individual stocks. Recent social security reform in Sweden will allow workers to direct 2.5% of their salary to individual accounts where they will have 450 funds to choose from. It is not yet clear how the social security reform in the United States will be accomplished, if at all. But self-directed investment of a portion of social security money is a possibility.
However, the question remains whether people make good choices and benefit from being able to choose their own portfolios. Indeed, people may not make good choices for many reasons. The next chapter discusses how psychological biases and emotions influence choices, usually in a bad way. Another problem is that people often don't really know how the choices they make now affect the realization of their future. Consider your current predicament. You may have preferences for the amount of wealth you want at retirement. You may have a total dollar amount (like $500,000 or $1 million) you want to acquire. Or you may define your preference as a monthly income in retirement. However, right now you are faced with forming a portfolio that will help you achieve those desires for the future. It probably isn't clear how your asset allocation into different investments, such as large and small cap stocks, international stocks, and bonds, will lead to your future success. In other words, the investment choices you face now are not well linked with your preferences for the future. If you don't have clearly defined retirement objectives, then your current choices are even further disconnected from your preferences.
Darren Winters
A lack of clearly defined investment preferences causes problems when you must pick your portfolio. For example, consider the options that confront the typical employee when selecting a 401(k) asset allocation. Different investment options entail different levels of risk. Your future wealth depends on the amount of risk you take and some luck. The luck is the result of not knowing how our economy and the stock market will perform over the next few decades. An investor who takes a lot of risk and invests much of the portfolio in stocks will be rewarded if the stock market does well and will suffer if the stock market suffers. Employees can invest their retirement money in low-risk, medium-risk, and high-risk options.
If your employer confronted you with the investment options, which options would you prefer? Rank the three options into your first, second, and third choice. Note that the options are ordered from the least amount of risk to the highest amount of risk. As you would expect, the more risk you take, the higher the potential rewards. However, there is also a greater chance for a bad outcome if the stock market does not perform well.
Thanks Darren Winters
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