How to stop sabotaging your own investments
I frequently get calls from investors concerned about a number of factors they feel can sabotage their effort to achieve investment goals: soaring government spending, rising public debt and interest rates are all valid concerns. However, there is another factor that can do even more harm to the performance of retirement accounts – investor behavior. It has been widely publicized that many investors act irrationally when making decisions about their investments. Behavioral economists, like Kahnemann and Tversky, have published extensive research about how we make decisions, some of which are not in our own best interest. Investment performance, whether positive or negative, can be a powerful force, influencing individuals to take actions without considering the long-term implications. Luckily investors have complete control of their investing choices. Understanding potential mistakes can help you prepare for the future.
Overconfidence
The general direction of the market can have a significant impact on the emotions that affect an investor’s action. Generally, a bull market will cause investor confidence to rise because many or all investment decisions will result in a positive return. Unchecked, this causes investors to become overconfident and allows greed to play a hand in their investment decisions.
In bear markets, investors will find that many or all of their investment decisions will result in negative or flat returns. In this type of market investors will tend to overreact and base their decisions on fear.
Fear
Market declines can have lasting effects on investors, continuing to affect their decisions well after the decline has passed. This is caused by the regret investors feel after they experience losses in their account. The level of regret increases proportionally to the level of losses experienced during declines.
Investors will act differently long after the bear market has passed in attempt to avoid feeling regret in the future. In many cases regretful investors will be tempted to move to a portfolio that is far too conservative or, in extreme cases, abandon their portfolio altogether in exchange for a relatively low fixed rate of return. This causes young investors to miss out on the compounding effects of the market and puts investors who are close to or in retirement at risk of having their nest egg degraded by inflation.
Selective information gathering
In many cases investors will seek out information that reinforces their current beliefs. Seeking out only information that reinforces one’s current beliefs satisfies the need to research a topic without the risk of discovering that your current logic is flawed. Investors who research topics in this way are not expanding their knowledge base or enabling themselves to make better investment decisions.
Investors who seek reinforcement of their current ideas will often try to bend reality when confronted with opposing information. They will insist that the information doesn’t apply to their situation – it’s different this time – or that they are too smart to fall in to the same pitfalls as other investors. In reality, an investor should not seek out information that supports any certain view. Instead gather a variety of information from various sources and points of view so that you can consider all possible outcomes of your decisions.
Herd mentality
Herd behavior has a tremendous impact on the decisions that investors make and the market as a whole. Many people fall into the trap of believing that if a large number of people are participating in a strategy then it must be good. Investors will seek out like-minded people to reinforce the belief that the most popular investment strategy is the best. As the herd behavior perpetuates, investors find it more difficult to resist blindly following. In these situations investors hesitate to be first to participate but fear being the last to get in.
The fact of the matter is that even large numbers of people can be wrong in the long run. We see this in the formation and bursting of bubbles in the market, the dot com bubble of the late 90s and the real estate bubble of the mid-to-late 00s to name the most recent. Herd behavior made these strategies grow as long as new investors came on board and paid progressively higher prices to get in. As soon as the flow of new investors stopped, the price support went away and the market sank.
You can limit the impact that these emotions have on your investment decision by taking a few simple steps.
- Make a thorough investment plan, review it regularly and stick to it. A plan provides a guide that will help you stay on track when the markets and the economy seem unsteady. Stay focused on your time horizon. Establish a portfolio that is appropriate for your time to retirement and resist the temptation to make drastic changes based on short term hysteria.
- Rebalance your account regularly to bring your allocation back in-line with your plan. Regular rebalancing forces you to sell off asset classes that have run up in price and add to those that are less expensive. In other words, regular rebalancing forces you to buy low and sell high, the core concept of successful investing.
- Avoid making decisions regarding your investments when you are feeling any of the emotions discussed above. It is never a good idea to react to how the market performs in the short term or to a particularly dramatic news story.
All of this can be a bit overwhelming. If you are not comfortable analyzing information and making decisions about your investments, consider seeking the assistance of a professional. An adviser can be a valuable tool to keep you on track through rough markets and to explain events that may impact your account.
Charlie Koch, Investment Adviser
About Smart401k
Smart401k is a Web-based investment adviser providing unbiased advice to help employees invest in their employer-sponsored retirement plans. Smart401k provides service to almost 11,000 clients who collectively have more than $1.5 billion in assets. Individuals receive personalized investment recommendations based on the funds in their plan and support of professional investment advisers available to answer all investment questions. Based in Overland Park, KS, Smart401k can be found at Smart401k.com.
