Investment Psychology

investment-psycologySmart investors understand that psychology plays an enormous role in investing. This is described in the field of Behavioral Finance: “A field of finance that proposes psychology-based theories to explain stock market anomalies. Within behavioral finance, it is assumed that the information structure and the characteristics of market participants systematically influence individuals’ investment decisions as well as market outcomes.”

For many years, financial scholars maintained that markets are rational and efficient. This was embodied in the “Efficient Market Hypothesis.” However, the many manias and wild market swings throughout history have undermined this theory.

“In the short term, the stock market behaves like a voting machine, but in the long term it acts like a weighing machine”
– Ben Graham

Investment Manias

Many investors have suffered huge losses from buying into popular asset manias near the top. Conversely, many have lost opportunities from selling unpopular, cheap assets near the bottom. This behavior devastates long-term results because of the powerful effect of compounding. Here are a few examples:

In 1987, the market crashed 22% in one day, but still rose 5% for the year. Those who sold at the bottom and stayed out for two years missed returns of 53%.

The S&P 500 index hit a market low of 676 on March 9, 2009, losing 56% of its value since the October 2007 high. The market then reversed course. Ten years later the index stood at 2793. This whopping 313% gain translated into returns of 17.8% per year. Those who sold at the bottom in 2009 missed one of the greatest bull markets in history.

The table below depicts how the “new economy stocks” of the internet bubble ruined investors. There are many other examples throughout history.

Source:  Malkiel, “A Random Walk Down Wall Street,” 2007, p. 81.

Source: Malkiel, “A Random Walk Down Wall Street,” 2007, p. 81.

The lesson is clear: investor behavior is a major determinant of investment performance. Investors might have excellent investment knowledge and strategy. However, their results will be determined by their behavior.

Psychological Challenges

It’s important to understand the behavioral challenges to following a disciplined investment approach. Among them are trying to follow these positive behaviors:

  • Doing nothing. Bucking the desire to be active
  • Sticking to your guns in a down market
  • Ignoring hot new investment opportunities
  • Not listening to friends who are making big money on a specific investment
  • Ignoring friends who might have a different allocation to equities
  • Dismissing investment, political and business news media hype
  • Living comfortably with “tracking error” (when your portfolio underperforms major market averages)

A good investment advisor can assist you with these challenges. For instance, in a bear market they act as a counselor, giving you confidence to stick to your plan.

Mistakes that Even Smart Investors Make

One of my favorite investment books is “Investment Mistakes Even Smart Investors Make and How to Avoid Them,” by Swedroe and Balaban. I believe this is must reading for all investors. It is an easy read for all levels of investors and lists 77 mistakes. Each chapter is chock full of compelling data and actionable advice.

I’ve compiled what I believe to be the Top Ten Mistakes in terms of negatively affecting your investing performance. Just in case you wondered, I have made some of these mistakes:

My Top Ten Investor Mistakes

  1. Attempting to time the market
  2. Not adopting and/or sticking to a long-term investment strategy
  3. Relying on bad advice from the wrong sources (e.g. brokers, TV analysts or friends)
  4. Investing in expensive mutual funds with loads and/or high expense ratios
  5. Chasing performance of recent winning assets or managers
  6. Adopting the wrong mix and/or weighting of assets – not having an investment strategy
  7. Not managing your assets properly to minimize taxes
  8. Investing based on hot tips or too good to be true “opportunities”
  9. Not understanding the risk-reward trade-off of your individual and total portfolio holdings; not building a portfolio that maximizes your results
  10. Being too active – buying, selling and changing holdings too much

I can’t emphasize enough the importance of self-awareness in your investing. Just reading about investment psychology can help you gain more awareness of your tendencies and possible weaknesses. As a result, you will make fewer mistakes.

My article “Uncover the Source of Your Negative Alpha,” describes my own experiences and mistakes. It is important to analyze your behaviors and implement self-correcting mechanisms to avoid repeating the same mistakes.

Here are more resources that can help you:

Background/Concepts:
Investopedia University: Behavioral Finance
Bogleheads: Behavioral Pitfalls

Research Paper:
Library of Congress: Behavioral Patterns and Pitfalls of U.S. Investors (pdf)

Books:
The Four Pillars of Investing, by William Bernstein
Your Money & Your Brain, by Jason Zweig