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An
Investor’s Worst Enemy Justus
Morgan “We have
met the enemy and he is us.” This quote made famous by Walt Kelly in his Pogo
comic strip sums up a relatively recent innovation called behavioral finance
that blends psychology and economics. The premise of behavioral finance is
that people do not always act rationally. On the surface this makes sense but
it has significant implications in economics and investing theory which are
primarily based on the assumption that individuals are rational. One topic
of behavioral finance that I find particularly timely today is the concept of
overconfidence. Overconfidence manifests itself in a number of ways when it
comes to investing and can be summed up by the assumption that you are a
better investor than others. This leads us to assume that our decisions will
lead to better outcomes than decisions made by others despite evidence to the
contrary. Typically, investors assume that positive outcomes are the result
of their skills and negative outcomes are attributed to factors outside of
their control. This leads to a host of problems of which performance results
are the most significant. An
ongoing study created by DALBAR, Inc. tracks the performance of individual
investors versus the stock market. DALBAR found the average stock investor
earned 4.48 percent from 1988 until 2007 versus 11.81 percent for the S&P
500 Index. The primary reasons for this drastic underperformance were the
tendencies of individuals to buy and sell at the wrong time and to hold their
investments for too short of a period. Why do
investors do this? They think they have superior knowledge or skill that will
allow them to outperform everyone else. This leads people to make decisions
based on emotions rather than facts. Professional investors suffer from the
same tendencies too. Just look at the performance of actively managed mutual
funds versus their benchmarks. One
strategy that concerns me the most involving overconfidence is the assumption
that great ideas make great investments. I regularly receive calls from
clients interested in investing in the latest news headline such as high oil
prices or other natural resource shortages. First of all, the mere fact that
they’ve had the idea means many others have too. Prices for stocks typically
react very quickly to new information so unless you have the ability to
predict the future, it’s going to be very difficult to successfully profit from
your idea. Another consideration
is the potential that you may already own the stock you are considering,
assuming you own a diversified investment portfolio. For instance, ExxonMobil
Corporation comprises 3.89 percent of the S&P 500 Index as of the end of
May. Energy stocks represent 14.41 percent of the same index. If you think energy
stock prices will continue to increase, then you already have a fair amount
of exposure if you own a fund comprised of the S&P 500 Index. So how
can we use the research from behavioral finance to improve our investment
performance? The best thing we can do is to be conscious of our natural
tendencies that often lead to poor decision making and to rely on diversified
investment portfolios to accumulate wealth rather than speculative bets on
the latest crisis. Justus
Morgan is a Certified Financial Planner with Financial Service Group, Inc., a
registered investment advisory firm in |