Investing and Behavioral Risk

investing decisions

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So, you bought that stock and expected it to return a pile of cash to pay your current debt.  How long has it been, four months?  You watch it every day.  It’s a good day when it goes up, if it goes down, it clouds your mood.  Today, it’s down 12%, maybe it’s time to sell?  You sell the loser and put the diminishing dollars into the bank or, worse yet, into another stock that you expect to skyrocket.  Within a few months, you’re disappointed again.  The cycle repeats.

 

Here’s a sobering thought.  If you’re not happy with your investment returns, it’s your fault.  If you’re new to investing, you would best follow research-based advice – it will alleviate future regrets.

To pick a winner and have it shoot into the galaxy in a short period of time is rare, and happens only by dumb luck.  Basically, you need to invest consistently while you do your life.  Investing wealth is what happens when you’re busy making other plans.  (This may sound familiar if you’re not a millennial.)

 

I dusted off a book that I read a year ago, The Laws of Wealth by Dr. Daniel Crosby.  Dr. Crosby emphasizes that effective investing has less to do with being a Wall Street genius and everything to do with human conduct.  The concept of behavioral risk is introduced as a companion to the familiar risk concepts, systematic risk and unsystematic risk.

 

The book analyzes nine faulty behaviors and the actions to avoid investing failures.

Here are some interesting highlights:

 

Thinking

What sets us humans apart from other mammals is the ability to think, and to think into the future.  Unfortunately, our brains are pessimists.  Because the human brain spends one of every eight hours contemplating the future, this leads to an obsession with negative events striking us down.  The predisposition to negativity affects investing decisions when it becomes the prelude for hasty decisions.

 

Almost every natural reaction that is triggered by stock market volatility is the wrong thing to do.  Investors tend to sell at their stock’s new low. A Dramamine would be more useful, staving off the nausea of the market’s mood swings.  The remedy is to dilute the mind’s chaos to offset the reckless moves. Test your mental grit here. Channeling your thinking to produce lucrative results in investing may feel unnatural and grind against natural inclinations but mental mastery wins in the end.

 

The Most Feared Concept in Investing 

One obscure reality that requires acceptance is that corrections and bear markets are part of the investment landscape.  When the market nose-dives, the natural reaction is to ditch everything.  That’s the herd mentality.  Try this instead: realize that it represents a golden buying opportunity.

 

Take this sharp right – create a list of stocks to buy when a bear market occurs.  I like this idea because it removes the anxiety associated with a pending market decline.  The concept gives permission to work up some excitement for the next correction, not fear it like the next plague.

 

As we speak, I’m putting some cash away for the next drop, it worked for me last time.  In 2009, I paid off my second car by buying GE at $7 a share.  (I wish I had put all my cash into it, but it’s too late to count money I didn’t make.)

 

 

Apply goals-based investing

Researchers found that of a pool of clients that focused on goals-based investing, 75% made no changes to their assets while 20% increased the size of their immediate needs pool but left their long-term assets fully invested.  Clients with a traditional investment portfolio fully liquidated their holdings at least once, even when they didn’t need the money, and 10% made significant changes (25% or more reduction) to their equity allocation.

 

Action Points:

Automate investing contributions consistent with a set of goals

 

Diversify and decrease volatility by investing in all five asset classes:

  • US stocks
  • Foreign stocks
  • Commodities
  • Real estate
  • Bonds

 

 

Earmarking

Earmarking, or bucketing, is a mind game and it can be effectively applied to investing.  Sometimes known as the envelope method, earmarking connects your goal to a specific personal element in your life.  For example, a separate bank account set up for savings sounds really dull, but the act of labeling envelopes with photos of the account’s purpose has proven to produce higher savings rates.  This mind framing creates mental buckets and personalizes the end result.

 

Have some fun with this.  Create a financial vision board and think big (on Pinterest).  Allow your mental energy to connect to your images.

 

Curbing Your Emotions

Here’s something you might not want to hear.  The hard truth is, emotions dictate investing and emotional investors run the risk of ending up broke.

 

Successful investors have learned how to contain their emotions and remain rational.  I have known people that are so emotional about money that they looked like they were in pain when paying for something at the check-out register.  Having worked in retail, I’ve witnessed many people express contempt for the employee collecting the money.  They forgot that money is an exchange for the merchandise that they’re carrying out of the store.  If you are extremely emotional about money and if “Don’t Sweat the Small Stuff” did nothing to quell your hair-trigger reactions, stay away from active investing. It’s not for you.  A passive investment, like an index fund, would suit you better.

 

Another virtue will come in handy – patience.  Over time, an impatient investor will experience more losses from perpetually making rash decisions.  You don’t want this to be you.

 

If you still want to actively invest, get your temperament under control.  There are a number of roads to take for this one.  You can start journaling, exercising, and talking out your frustrations.  Control what you can, e.g., researching a company and buying at the right price.

 

Challenge yourself to rein in poor habits.  Try some of these suggestions and see if you can work them into your investment mentality:

 

  • Offset overconfidence by sticking with your plan
  • Don’t try to predict the future, but prepare for bad times
  • Don’t expect permanence; whether in good times or bad, ride the waves
  • Manage risk by studying fundamental factors
  • Measure performance against your own gains, not others’

 

Good Investing Is Boring

I like this quote from George Soros:

“If investing is entertaining, if you’re having fun, you’re probably not making any money.  Good investing is boring.”

 

There is no escaping the fact that managing human behavior is the key to being a successful investor.  No level of investment skill, which is rare on its own, is sufficient to overcome debilitating behavior.

Where can you improve your investing behavior?

 

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