Man is the only kind of varmint who sets his own trap, baits it, then steps in it.
~ John Steinbeck
Question: Eager to begin the New Year with a fresh start, I’m wondering what separates successful investors from those who obtain mediocre or poor results?
Answer: As the John Steinbeck quote above implies, we tend to be our own worst enemies. It’s safe to say that the classic emotional and psychological traps fall into five categories. These pitfalls, left unchecked, can sabotage otherwise sound financial planning.
Trap 1: Overconfidence
We trust ourselves, and for good reason. We think we know what we know. But in the investing world, that leads to overconfidence and miscalculations. Too much self-assuredness may cause us to inflate potential upside likelihood while minimizing downside possibilities.
Caution flags: If you find yourself saying, “Nothing could ever go wrong,” or “I know the company and the risks,” you may have a problem. Remember that every investment carries some risk and the potential for losses.
Shatter the illusion: Company employees and executives may believe that they have abundant knowledge of a company’s fundamentals because they helped build it. That may be true, but does it make sense to tie up 40% of your portfolio in one position? There are reasons for diversifying a portfolio. Remember Enron?
Trap 2: Mental Accounting
Mental accounting tricks your mind into compartmentalizing certain investments. Sometimes it’s based on the sentimental fact that your grandfather gifted it to you. Favoring one investment exclusively over another can hinder long-term investors. Positions work best when the entire portfolio works in harmony to manage risks and move toward established goals.
Caution flags: If you find yourself saying, “But I love that stock,” you may have a problem.
Shatter the illusion: “Don’t ever fall in love with a stock; it’ll never love you back.” The cliché is actually sound advice.
Trap 3: Benchmark Bias
Comparing your portfolio’s rate of return to a broad market index rather than assessing if you’re making progress toward your individual goals – and this part is key – may cause you to take on excessive risk.
Caution flags: If you find yourself saying, “Did I beat the S&P?” or if you try to outperform TV’s talking heads, you may have a problem. This behavior may divert you from the original logic used to position your investments, which should match your temperament and your financial needs.
Shatter the illusion: Focus on movement toward your end goal. If you’re a long-term investor, what matters most is attempting to achieve steady performance over long periods of time, not the daily, monthly or quarterly performance of the benchmarks.
Trap 4: Herd Behavior
As social beings, we’re hard wired to be part of the group. We generally tend to go along with the crowd. This is the same behavior that builds bubbles. Usually, by the time everyone has heard about a trend, it’s too late to benefit from continued upward momentum.
Caution flags: You may have a problem if you find yourself chasing performance or rushing toward the exit during turbulent times: this is otherwise known as buying high and selling low, the opposite of what we want.
Shatter the illusion: Large institutional investors establish investment policy statements to make sure they stick to an agreed upon and outlined strategy. Think like an institutional investor, unemotionally weigh the merits of an investment’s ability to obtain your long-term goals.
Trap 5: Ignoring Reality
It’s scientifically proven that we regret our losses more than we enjoy our winnings. Loss aversion may cause us to hold underperforming stocks in hopes of one day making up for the declines. Anchoring plays a part here, too. We establish certain subjective milestones in our minds. Once reached, we’ll take action. But if not, we may ignore changing markets to our detriment and overstay our welcome with particular holdings.
Caution flags: You may have a problem if you say, “I don’t want to lock in a loss” or “I’ll sell when it gets back to where I bought it.” There is a tendency to hold investments longer than necessary hoping that they’ll recover.
Shatter the illusion: Let your portfolio do what it was built to do. Every year, something will win or lose, that’s why you should be diversified with non-correlated holdings.
Gaining Experience and Perspective
Adhering to a sound investment philosophy may be one of the most difficult, yet best ways to avoid the traps set by our brains. That may seem boring, but it can be an effective way to attempt to meet your goals.
If you find yourself wanting – or needing – to take action out of hope, fear or regret, ask for help and get a reality check. A trusted financial advisor will remind you why you’re invested the way you are. He or she is an educator, counselor and sounding board to steady your emotions, as well as your portfolio.
Investing involves risk including the possible loss of capital. There is no assurance that any investment strategy will be successful. Asset allocation and diversification do not guarantee a profit nor protect against loss. The opinions expressed are those of the writer, but not necessarily those of Raymond James and Associates, and subject to change at any time. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed.
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This article provided by Darcie Guerin, CFP®, Vice President, Investments & Branch Manager of Raymond James & Associates, Inc. Member New York Stock Exchange/SIPC 606 Bald Eagle Dr. Suite 401, Marco Island, FL 34145. She may be reached at 239-389-1041, email firstname.lastname@example.org Website: www.raymondjames.com/Darcie.