Wednesday, 15 January 2014

Seven psychological quirks that destroy investment returns

Making money from stocks is easy enough if we can defeat the main enemy – ourselves. There’s no getting around the fact that us humans are subject to lots of biases and psychological quirks that combine to destroy our investing returns.

The first line of defence against this is to recognise the problem.

Here are seven psychological quirks to look out for.

1. Overconfidence and optimism
Most of us are way too confident about our ability to foresee the future, and overwhelmingly too optimistic in our forecasts.

This finding holds across all disciplines, for both professionals and non-professionals, with the exceptions of weather forecasters and horse handicappers.

Lesson: Learn not to trust your gut.

2. Hindsight
We consistently exaggerate our prior beliefs about events.

Market forecasters spend a lot of time telling us why the market behaved the way it did. They’re great at telling us we need an umbrella after it starts raining as well, but it doesn’t improve our returns. We're all useless at remembering what we used to believe.

Lesson: Keep a diary, revisit your thinking constantly.

3. Loss aversion
We hurt more when we sell at a loss than we feel happy when we sell for the same profit. But stocks don’t have memories – decisions on whether to buy or sell should always be independent of your buying price.

Lesson: Ignore buying prices when deciding whether to sell.

4. Regret
Investment decisions should overwhelmingly be about risk, and risk implies a judgement, which may turn out to be wrong, often through bad luck rather than bad thinking.

Becoming overly focused on past decisions that have gone wrong without analysing whether the decision made was rational under the circumstances isn’t rational. Investing involves making mistakes and is often down to luck.

Lesson: Learn to live with mistakes.

5. Anchoring
Ten years or so of research have shown we have a nasty tendency to ‘anchor’ on specific numbers. Psychologists can change the results of simple estimation questions (for example, how old do you think Woody Allen is?) simply by posing an earlier unrelated question containing a number.

Lesson: Don’t get fixated on specific numbers, such as buy prices, stop loss prices or index values.

6. Recency Bias
We pay more attention to short-term events than the longer-term. So the effect of a short-term downturn in a company’s fortunes may be exaggerated, or we may simply assume that current market conditions will persist forever.

Lesson: Buy some history books, and look beyond the short term.

7. Confirmation Bias
We just love other people to confirm our decisions. And other people just love us confirming their opinions. In fact we could just get together and have a regular love-in but it doesn't make for good investing. The only money you lose is your own.

Lesson: Make your own decisions; don't worry about what others think.

Special bonus quirk!
As a bonus investment quirk, my all-time favourite is Myopic Loss Aversion. This is where investors can’t stand the sight of red ink in their portfolio – they avoid short term losses at the expense of long term gains.

Such people should be physically restrained from buying stocks. Let them play checkers with five-year olds or something they can always win at.

Many people who invest heavily in stocks tend to heavily exaggerate their own abilities and downplay the role of luck in stock market investment. Sadly there is a lot of random stuff in the market which we can’t control.

The easiest way of managing these psychological ticks is to invest regularly and for the long term in index trackers and avoid selling no matter what the circumstances.

Failing that – go take a course in weather forecasting. At least you'll be more help than most market forecasters who can only tell you that you need an umbrella after it starts raining.