Behavioral Finance: Why Kevin, Janet, Bruce and Carrie Made the Investment Decisions (and Mistakes) They Did
I recently attended a workshop where I had the opportunity to speak with several investors. Four stand out in my memory for the mistakes they made. Do any of them sound a bit like you?
Kevin: Aversion to Risk
Kevin, in his mid-50s, had always been afraid of the stock market. Most of his retirement money was tied up in fixed income securities, predominantly a mutual fund composed of Treasury bonds and notes. He did invest a little (about 15%) in a mutual fund consisting exclusively of blue-chip American stocks.
Kevin had come to realize the weaknesses of his investment strategy. His returns have barely kept up with inflation, and had they not been tax-sheltered, they would have been even smaller. His lack of diversification meant that most of his returns depended on the performance of one asset class.
Kevin was the first to admit his fear of sustaining investment losses, even those only on paper. In reality, his “conservative” investment strategy was anything but. He had exchanged the stock market volatility (and the accompanying opportunities) for the “sure bet” of interest income. That sure bet crippled his returns and prevented him from hedging his bets.
Had he pursued an investment strategy of diversifying his portfolio over a wide array of asset types, he would have reduced the portfolio’s overall volatility while increasing his potential returns. After the workshop, Kevin agreed.
Janet: Following the Herd
Janet, 34, was confident in her ability to pick suitable investments despite a busy life that left her little time for research. The source of her confidence was the cable network she watched. Every day, she was bombarded by a mixture of reports about the latest micro-movements in the various markets mixed with an endless stream of commentators sharing their opinions of where the markets were going.
The result was that she tended to invest based upon the prevailing opinions expressed on the cable channel. Most of the time, this meant hopping aboard the current trend. In other words, she was following the herd.
Janet’s “strategy” had stung her several times. She had a habit of locking in losses by selling her stocks during a bear market or piling into shares near market tops. Her returns suffered, as did the returns of many of the workshop attendees, from paying too much attention to short-term market volatility. She had no fundamental knowledge of why she traded as she did other than exposure to the random opinions of others.
A good financial analyst would have worked with Janet to establish an asset allocation strategy that matched her goals, income, and age. Rather than concentrating on hot stocks, she would be advised to invest in ETFs, mutual funds, REITs, and other diversified instruments that she would rebalance only once or twice per year.
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Bruce, in his late 20s, loved trading stocks. He loved it so much that he did it every day. Bruce might read about a stock achieving a new 52-week high and immediately have the overpowering need to own several hundred shares. He would sell any stocks that lost 20% or more, although he had no strategy for reaping the rewards from his winners.
Bruce’s worst fear was missing out on some hot action profiting others. His FOMO meant that he was consistently buying high and selling low. Unfortunately, his poor results only fueled his trading fever. The biggest winner was his brokerage, which made thousands each year in commissions.
In speaking with Bruce, I urged him to examine his behavior to see how it interfered with his long-term ability to accumulate wealth. Hopscotching from one stock to the next bespoke of a gambler’s attitude, not that of a prudent long-term investor. Luckily, Bruce is young enough to recover from his financial losses and has plenty of time to invest for his retirement the right way.
I would suggest that Bruce allocate 90% of his purchases to a strategy of dollar-cost averaging – investing a fixed amount each month in a predetermined set of allocation ratios. This strategy would allow him to purchase more shares when prices were low and fewer when high. It would also allow him to diversify his holdings. Bruce could then use the remaining 10% to satisfy his gambling habit without crippling his overall returns.
Carrie: Going It Alone
Carrie is a lovely lady who tends to see the world through rose-colored glasses. She doesn’t feel the need for professional investment advice because of her gut feeling that “things will work out.” The result was that she fell in love with the stocks she owned and never sold them. Her portfolio was cluttered with a hodge-podge of stocks, some doing quite well but many trading far below her purchase price.
I would have advised Carrie to seek the assistance of a clear-eyed financial planning professional who could provide a realistic perspective about the risks of investing and how to handle them. Most importantly, it’s not a good idea to fall in love with your stocks, and in fact, it’s not necessarily a good idea to pick individual stocks at all unless you have the time and expertise to do a good job.
Fund investing is a way to participate in the markets without taking on the risk of holding significant positions in individual securities. By holding diversified funds in a wide range of asset classes, she can reduce her unsystematic (i.e., company-specific) risk. Moreover, she can also reduce the chances that all her assets would go down simultaneously since uncorrelated asset classes can hedge each other. In short, Carrie would benefit from the input of a financial advisor with a fiduciary obligation to offer her advice in her own best interest.
Perhaps some of you can identify with one or more of these remarkable people. But whether you do or not, I’m convinced that you’ll improve your investing results while lowering your overall risk by working with an accredited investment professional. Consider getting a second opinion from a professional.
Schedule a no-obligation conversation with me directly. Best case scenario, we verify that the strategies you are taking make sense. If they’re not, this simple conversation can be a game-changer!