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Investor bad behaviour: buy high, sell low

April 4, 2014 by InvestingForMe

 

As we outlined in our previous article, DALBAR Inc.’s annual studies identify 3 main reasons why investors consistently under-perform the investment indices:

  1. bad investor behaviour
  2. high investment costs, and
  3. high investment Portfolio Turnover Ratios (PTRs)

Of the three reasons listed above, #1 (bad investor behaviour) is the biggy – accounting for over half of all lost investment returns.

Bad investment behaviour = bad investment returns

When it comes to our investment decisions, it turns out that our emotions always seem to get the better of us. Specifically, DALBAR finds that no matter how smart we think we are, we still let our greed and fear dictate our investment choices. When markets rise to new highs, our greed makes us overpay for riskier and riskier investments. And when markets fall, our fear of losing our hard-earned savings makes us sell, and the pain from losing money keeps us on the sidelines longer than we should.

Note: Interestingly, lots of us prefer to hand our hard earned savings over to the professional money managers (the pros) thinking they’ll be better at making investment decisions than we are - free from any of that bothersome greed and fear, right? Not!

Even the pros constantly battle with their emotions when it comes to investing your savings. They don’t worry about losing your money, but they do worry about their careers. Career risk feeds their fear of under-performing their professional peers (i.e. losing that next bonus or promotion, or maybe even their jobs). Plus, their greed is replaced by ego, where they want to outperform their peers and gain status as the next great investing guru. So don’t ever assume that the guys you hand off your savings to are some kind of emotionless robots, because they’re not!

Step 1: Know thyself: accept that you’re an emotional weakling

As with any chronic problem, the first step in correcting the problem is to acknowledge the problem exists. Then we can take the necessary steps to ensure the problem is minimized or eliminated.

So if we accept that our emotions make us do dumb things – like buying at the top of markets and selling at the bottom – we can learn to make wiser investment choices that don’t feed those emotions.

Note: Buying an investment at the top of a market cycle can be problematic, but the real dumb behaviour and consequent damage to our savings is done when our fear of losing money feeds our decisions to sell at the bottom of markets. So, when it comes to our bad behaviour, it’s really our fear of losing money that we need to manage better.

Step 2: Use an investment’s performance standard deviation to help

As we discussed in our previous article, an investment’s performance standard deviation is a measure of the investment’s past volatility and it can help you to set realistic expectations for future price changes, and those expectations (or warnings of possible ranges) can prevent you from pressing the panic button and going back down the road of bad investment behaviour.

For example, if we buy an investment that has averaged a 7% rate of return and it has a performance standard deviation of + and – 20%, then we know the investment’s annual performance was between a gain of 27% and a loss of 13% in 68% of the time (one standard deviation from the average 7%). But we also know that in 95% of the time (two standard deviations from the average 7%), the investment’s annual performance was somewhere between a gain of 47% and a loss of 33%. Now, that’s a big range (+ 47% to – 33%)! So, making a cool 47% isn’t going to be a problem! But while I can happily handle that outcome, watching my savings drop by 33%, on the other hand, which is the opposite possible extreme as indicated by the investment’s performance standard deviation, would not be fun and might scare me back into that bad investment behaviour cycle of selling at a bottom market.

So then what?

Step 3: Finding the right emotional fit

So, knowing that we are investing emotional weaklings, if we have a better understanding of the potential volatility in the investment’s future performance, then we can better manage our emotions and our investing decisions – which is short for … have more fun money in our retirement.

That means that when you’re looking for a new investment, if you think that watching your savings lose 33% in a short time frame might scare you into selling, then maybe you should look for an investment that better suits your emotional limits. Maybe an investment that averages 5% with a performance standard deviation of + and – 10% is a better fit with your emotions. (Reminder: An investment with this type of performance standard deviation will provide a rate of return somewhere between a gain of 15% and a loss of 5% in 68% of future years. And in extreme years the investment’s performance might be between a gain of 25% and a loss of 15% in 95% of future years.)

But it’s up to you. You have to know what range of performance you’re most comfortable with. But choosing investments that are a better fit with your emotional limits will help you to minimize your bad investment behaviour (not buying high and not selling low), decrease your investing under-performance, and help you to reach your financial goals a lot sooner.

Next time we’ll tackle the second biggest contributor to our investment under-performance – high investment costs!

 

Read the next article in this series - Get out of the trap: find out how much your investments are costing you

 

Read the first article in the series - The average investor: chronic underachiever

 

(Published by Troy Media)

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