The markets took another beating yesterday with the S&P/TSX plunging 756 points to fall below the 8,000 mark for the first time since 2003, closing at 7,735 and the DJIA fell 360 points to close at 7,637. The events of this week are sure to keep investors questioning their actions or inactions with respect to their investments and whether or not they should ‘do something’.
The well-studied principles of investor behavior are a large part of what moves our markets both up and down. Investing strictly on facts and discipline is difficult – after all, we are humans processing information with all the emotions, biases and shortcuts that get in the way.
Herd Mentality, Loss Aversion, Fear of Regret – these are the names given to just some of the various behaviors that cause people, as emotional beings, to make mistakes in their investment choices again and again.
One such behavior called “Overconfidence” occurs where investors make errors in overestimating the accuracy of their opinions and information, often due to past investing ‘successes’.
As a whole, overconfident investors trade too much. In a study I recently read, 78,000 households were divided into five groups based on trading frequency. The average portfolio return for the highest trading frequency group was almost 40% less than that of the lowest trading frequency. Along with trading frequently, overconfidence often leads to purchasing the wrong investments.
In another study, the same researchers followed brokerage accounts that sold a stock and bought a replacement stock shortly after. In the four months following the trade, the stocks that were sold on average earned 2.6% vs. only 0.11% earned by the replacement stocks. After a year, the stocks that had been sold outperformed the replacement stocks by 5.8%.
Of course this data, while reliable in it’s own context, does not necessarily apply to today’s market conditions. However, the behavioral finance theory certainly does.
It is very important to truly understand why you are selling or buying a certain stock. If it is for technical analysis reasons, understand the risk-reward scenario and the charting pattern your are following. If it is for fundamental reasons, understand the company and what drives revenues and expenses. Don’t listen to the talking heads in the media – they make money spreading bad news and driving down investor confidence – also known as emotion.
As hard as it is, emotion is best left at the door when dealing with your investment portfolio.