Investing “Dos and Don’ts”

When it comes to money, people can often behave illogical, irrational, and become susceptible to certain economic mistakes. Having met with thousands of people before and during retirement, we know this to be true. What kind of mistakes do we see? Spending too much money, taking on too much debt, borrowing at unfavorable rates or conditions, not saving enough for retirement, selecting a poor advisor, selecting a poor investment vehicle, or implementing a poor investment strategy. The list goes on and on.

So how does the average consumer start making better financial decisions? Here are a few ideas that can help us learn and improve. Current market conditions provide a good backdrop for these “dos and don’ts” that can help each of us to be a better investor.

Do Recognize Your Biases

Confirmation Bias

Confirmation bias is when a person looks for evidence from the outside to confirm his or her belief. With a wide spectrum of news sources, including social media, it is not difficult to find someone or something that agrees with our reasoning. This could be with regard to the latest stock that we want to buy or about the political environment. Confirmation bias may be a natural response to cognitive dissonance, the mental discomfort that occurs when new information conflicts with prior held beliefs. One way of minimizing confirmation bias is to have someone we trust play devil’s advocate and question our thinking or to review legitimate sources of information that may provide a different perspective than what we have.

Overconfidence Bias

Everyone from Warren Buffet to the novice investor is subject to them. We cannot escape them. They are part of who we are, because of our knowledge and experiences and how we feel and interpret things. Biases can influence us to take too little risk or too much risk, to misallocate our investments, or to trade too often or at the worst times. There are many, but I will only list the biases that affect investors – conservatism, confirmation, representativeness, an illusion of control, hindsight, anchoring and adjustment, mental accounting, framing, availability, loss-aversion, overconfidence, self-control, status quo, endowment, and regret aversion. The good news is that most of these can be mitigated through education and awareness. What I believe to be the main biases that most investors face today are – confirmation bias, overconfidence bias, and loss-aversion bias.

Loss-Aversion Bias

Loss-aversion bias is an emotional bias that indicates that people strongly prefer avoiding losses as opposed to achieving gains. Psychologically, losses are more powerful than gains. The utility derived from a gain is much lower than the utility given up for an equivalent loss (see Exhibit 1). Those experiencing loss aversion may hold onto losing positions, so as not to realize losses, while selling winning positions too often, even though an objective analysis doesn’t warrant selling. Avoiding pain from losses may be impossible for some, but analyzing investments and realistically considering probabilities of future losses and gains may help individuals come to a more rational decision and develop realistic expectations.

Exhibit 1. Loss-Aversion Bias

Do Be Open-Minded

Regardless of how many mistakes you have made, you can still learn from them and you can still improve yourself. Even the greatest of investors have often made large mistakes. If you feel that you haven’t made many mistakes or are young and just getting started, you can still learn from the mistakes others have made. These can be related to how much you risk, what your goals and priorities should be, how you save, how you invest, how you spend, and how you pass this knowledge on to children, grandchildren, and other loved ones.

Don’t Be Overly Concentrated in Any Stock, Sector, or Region

Being diversified may mean that you don’t perform as well as the person at the cocktail party who claims to be up 900% for the year by having the bulk of their assets in Bitcoin (see Exhibit 2, flat yellow line is the S&P 500), but it will also guarantee that you won’t lose everything if that one stock you own happens to be the next Enron or Worldcom and it makes up 80% of your portfolio. Even for the companies that don’t fail, buying a large portion of something after it has already gone up by more than 1000% in a year is rarely prudent (see Exhibit 3, Qualcomm in 1999, flat yellow line is the S&P 500). There is a reason why we have a systematic process in place to rebalance portfolios. This process ensures that positions and risk exposures don’t increase in any one area as the systematic selling of positions keep exposures from getting too high.

Exhibit 2. Bitcoin

Don’t Get Distracted

The era of the smart phone was supposed to mean that we could be more productive, but all too often individuals get drawn in and distracted by all the different things that are literally at their fingertips – email, text messages, social media, hundreds of apps, and the internet. I like to refer to this as shiny object syndrome. For the media and advertisers to hold our attention, they have to come up with newer and more creative ways to hold our attention, often saying or doing things that are outside of the norms.

Exhibit 3. Qualcomm

Those on CNBC would rather talk to experts about their hot stock tips than about a steady, risk-managed and diversified portfolio. When stocks miss or beat their earnings estimates, the media loves to show how and why the companies are performing the way they are and love to highlight what “the experts” are saying. The hype and excitement gets people’s attention. While this information can sometimes be informative, it can often lead to unintended consequences of a desire to sell or buy at exactly the worst time. Sadly, statistics bear out the fact that investor returns underperform the market. A recent look through Morningstar’s institutional database showed that the 10 year annualized return of the Vanguard 500 Index fund was 7.39% through 10/31/17. The investor return, which accounts for money flowing into and out of the fund, was just 2.8% for the same period. Had investors of the fund stayed invested the whole time, they would have earned more than 4.5% extra per year. Shiny object syndrome may have contributed to some of this. Staying focused and disciplined can help us avoid many of the shiny objects and distractions that are out there.

Don’t Get Greedy When Markets are Surging

It is often when the market is fully or over-valued that individuals and institutions want to participate even more. Because of the overconfidence and confirmation bias feedback loop that is emitted from some professionals and the overwhelming positive investor sentiment that usually goes along with it, many investors desire to increase their risk exposures at precisely the wrong time. Consensus, Inc and Bianco Research recently highlighted a survey of investor bullishness that illustrates this well (see Exhibit 4).

Exhibit 4. Stock Indices Consensus Data

Surveys like this are usually a good contrarian indicator that now is not the time to increase risk. Investing legends such as Warren Buffet or Howard Marks are great at reminding us that while buying a good company matters, paying the right price also matters a great deal. When individuals feel like the market can only go up, they may believe that the price paid doesn’t matter so long as it keeps going higher. This may be true for a period, but it is rarely sustainable. Buffet has opined that investors should be fearful when everyone else is greedy and be greedy when everyone else is fearful. Don’t get greedy by increasing your exposure to risky assets when the markets are overheating. They may be much closer to the top than they are to the bottom.

Summary

Incorporating these “dos and don’ts” may not be easy, but it will be well worth it. Dealing with one’s biases can be especially tough. You may feel pressure from others to join the herd of the latest investment fad or to sell when everyone is panicking. Or you may feel the constant enticement of shiny objects or investments that would not be in your long-term best interest. Following the “dos,” however, will also make it easier to avoid the “don’ts.” Being aware of and having a methodical approach to deal with one’s biases, having an open mind, and always being grateful can help you more to learn and improve, both of which are incredibly empowering and invigorating, not just for investing, but for life.


Source: Charts and data referenced here come from Bloomberg.
The S&P 500 Index is a broad based unmanaged index that consists of the common stocks of 500 large capitalization companies, within various industrial sectors, most of which are listed on the New York Stock Exchange.
Past performance does not guarantee future results. Any stock market transaction can result in either profit or loss. Additionally, the commentary should also be viewed in the context of the broad market and general economic conditions prevailing during the periods covered by the provided information. Market and economic conditions could change in the future, producing materially different returns. Investment strategies may be subject to various types of risk of loss including, but not limited to, market risk, credit risk, interest rate risk, inflation risk, currency risk and political risk.
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November 20, 2017
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