Apr 23, 2017
Behaviours that kill your investments: Do you suffer from these?
Sitting wondering where the year has gone and that you are no wealthier for it? Or what has happened with your financial goals of building wealth?
It’s time to sit down, take 20 minutes and think about if you may be suffering from one of the following behaviours! This episode is on four behaviours that will destroy your ability to grow wealthy through investing.
1) Myopic risk aversion
Myopic risk aversion is one of the greatest behaviour traps that people repeatedly fall into leading to investment losses. While it is a fancy title, it simply means the fear of loss in the short term which occurs regardless of intelligence or skill level.
Loss aversion is completely rations, however it’s the myopic or in other words the short-term part which is irrational.
There is a saying in the share market that the Bulls take the stairs and the Bears take the window. A Bull market is when the market is going up (like a bull bucking its horns) while a Bear market is one that declining in value (like a bear swiping down with its claws). This can be seen in charts of any index where gains occur slowly while declines occur quickly. This is because investors feel the pain of losses far greater than they feel the pleasure of gains. We all have a natural and healthy aversion to losing money, helping us avoid falling for financial scams and protecting our capital.
But short term loss aversion is different. It happens when we temporarily lose sight of the bigger picture, and focus too much on what lies immediately in front of us. For investors, this usually means panic selling during sharp market declines.
Think back to 2008 in the GFC when everyone was selling shares out of the fear that the share market was going down. This created a self-fulfilling prophecy that caused markets to go down further. A lot of company’s earnings didn’t decrease however their share prices fell by up to 40%. Rationally, if their earnings didn’t decrease then their prices shouldn’t have either.
Economists have found that investors who check the performance of their portfolios too frequently suffer from this at a greater rate. If you check your investments on a daily basis, you will experience many days of losses which will create a greater fear of loss. Given that investors feel the pain of losses far greater than they feel the pleasure of gains, you may start to feel greater levels of pain and panic and sell investments, resulting in guaranteed long term losses. This has become a greater problem now with the internet, as most investors now have the capability to check on investments in real time. This can easily cause investors to stray from a well-thought-out investment plans causing investments to be sold at low prices which is the best way to lose money consistently in investments.
So, what can you do? It is simple, don’t freak out and sell investments when they suffer short term losses all because of a declining market. Volatility (upward and downward movements) will always occur in any liquid market, however if you have quality investments there is no reason to sell. Stop checking on the performance every day as this will compound the feelings of loss. Invest in quality assets and hold on to these for the long term.
2) Prospect Theory
A major investment mistake is created through erratic behaviours like changing your risk tolerance based upon what financial markets are doing. Making emotional decisions rather than sticking to your long-term wealth building strategy is one of the greatest ways to lose money when it comes to investing.
Prospect theory is a behavioural economic theory that describes the way people choose between probabilistic alternatives that involve risk, where the long-term probabilities of outcomes are known.
If you're the type of person who takes big risks in one area but takes almost none in another with similar likely outcomes, you might be suffering the effects of prospect theory. For instance, you are okay placing a bet on the Melbourne Cup but are afraid of investing as you may lose money.
The theory states that people make decisions based on the potential value of losses and gains rather than the final outcome and these outcomes are determined by your individual bias at the time. If the media is reporting on the next crash (before it occurs) then some people may become very conservative and sell investments or avoid investing.
The best way to avoid this is to always focus on what your long term outcomes are and to stick to your plan!
3) Herd behaviour and following the crowd
A financial market is made up on thousands of different assets which millions of people regularly buy and sell. The behaviours of either buying or selling these investments is what causes these markets to move in a certain direction. If more people are selling investments than are buying them, then the market will likely decline in value. If more people are buying investments than are selling them, then the market will likely increase in value.
It is this mechanic that can lead to investors following the trend of what the masses are doing, affecting their investment decisions. This comes back to myopic risk aversion as well as in the short term, who wants to be wrong? If others are selling their investments and we are not, what do they know that we don’t? It is this fear of missing out that causes investors to make irrational decisions.
It is ironic though as following the market will likely inflict the maximum pain on investors as many individual investors miss the start of the trend and make their decisions too late. For instance, buying at the peak of the market or selling after a big loss has already occurred.
This is the concept of herd behaviour, as the problem with being a follower is that the leaders are the ones that will make the money while the followers are making their decision too late. This is how bubbles are formed as well as when investors are buying an over demanded asset, it will cause the prices to increase above their long-term averages which is normally the point the average investor buys in to the market.
To avoid this there are two simple things that you can do. The first is ignoring the crowd and focusing on your investment strategy. The second is to implement contrarian investing - buying when people are fearful and selling when people are confident. This is one of Warren Buffets favourite tips for investors.
4) Analysis paralysis – Diminishing marginal returns
When deciding to invest, you have thousands of shares to choose from and almost as many managed funds and ETFs to sort through. This can cause investors to seemingly research ideas and different investment options forever.
At some point though, if you wish to make money through investing you are required to ''pull the trigger,'' so to speak. Researching investments is great, but over researching will cause a lot of investors to never actually enter the market as there is always one more investment to research before making a decision.
It is important to research investments, however there is a difference between selecting one investment that meets your need and trying to research 100 different investments that are all relatively similar. There is a concept call Diminishing Marginal Returns. This states that the longer you spend doing a task, the lower the results for each unit of time spent are after a certain point. Think about if you know nothing about cars. You spend a day learning about how they work. You may now know 50 percent of things about cars. You spend another day, you may know another 25 percent. You spend a third day and only know another 10 percent. After a certain point, every day you spend researching will only yield minor increases in knowledge.
Based on this, the more time spent researching doesn’t lead to better decisions. To avoid this, firstly focus on what your outcome is. If you are after long term growth, maybe research a few of the leading growth ETFs and then purchasing one or two. It is a better way than trying to research every share that the ETF holds, which would take your research from 2 two options to up to 300 in some cases.
It may feel uncomfortable but just pull the trigger as it is better to be invested in quality assets than trying to research the next big win.
Hopefully learning about these behaviours will help your stick to your long-term investment plans. Historically, markets will always have negative periods. All that matters is that in the long run they have greater positive periods than negative and to stick to the plan!