3 Psychological Stumbling Blocks That Kill Investor Profits

by Keith Fitz-Gerald | August 14, 2012 2:28 pm

Let’s face it: The past decade and more has been horrible for most investors.

This is not necessarily because the markets have been rocky, but rather because the vast majority of investors are hardwired to do three things that kill returns.

You can blame Washington, the European Union, debt, high unemployment or half a dozen other factors if you want to, but ultimately, the person responsible is the same one staring back at you from your bathroom mirror in the morning.

That’s why understanding the bad habits you didn’t know you had can be one of the quickest ways to improve your financial wealth.

Here’s what I mean:

Dalbar, a Boston-based market research firm, produces annual research that compares the returns of stock and bond markets with those of individual investors. And the latest report shows that the average equity fund investor underperformed the S&P 500 by 7.85% in 2011.

And fixed-income investors didn’t do any better. In other words, investors’ self-defeating decisions contributed to this underperformance, which has taken place for the last 18 years.

Why?

Three reasons: recency bias, herd behavior and fear.

It’s All About Perspective

Recency bias is what happens when short-term focus trumps long-term planning and execution. It’s what happens when somebody yells “fire” and everybody runs for the same exit at once despite having entered through any of half a dozen doors in the auditorium. Simply put, recency is recent knowledge that overrides longer-term thinking and memory.

This is why momentum trading works, for example, or the news channels seem to cover the same stocks at nearly the same time — because a huge number of people are focused on exactly the same companies simultaneously. Logically, they then become the subject of increased attention and tend to move more strongly or consistently.

The question of “why” is the subject of much debate among human behaviorists, but I chalk it up to the fact that human memories tend to focus on recent events more emotionally than they do longer-term plans that are put together with almost clinical detachment.

And the more extreme the events or the news, the sharper our short-term focus becomes.

That’s why, according to Mood Matters, a book by Dr. John Casti, one of the world’s leading thinkers on the science of complexity, “bombshell events are assimilated almost immediately into the prevailing (social) mood,” whereas longer-term cycles bear almost no witness to gradual change.

If that doesn’t make sense, think about what happened on 9/11. Most of the world’s major markets bottomed within minutes of each other on short-term panic and emotion. Then, when trading resumed days later, they began to climb almost in sync as highly localized events once again faded into the longer-term fabric of our world.

And that brings me to herding.

The Herd Mentality

We’d rather be wrong in a group than right individually, so the vast majority of investors tend to make decisions, and mistakes, together en masse.

You can see that in market data suggesting we have a fine tradition of doing exactly the right thing at precisely the wrong time. Instead of buying low and selling high, most investors tend to sell low and buy high, further damning themselves to sub par returns.

A lot of studies suggest this is the case, but none is as interesting as that by Philip Z. Maymin, an assistant professor of finance and risk engineering at Polytechnic Institute of New York University.

Maymin scrutinized records kept by the investment firm Gerstein Fisher from 1993 to mid-2010. Professor Maymin’s work included analysis on more than 1.5 million interactions between the firm and its clients and made a staggering finding. The value of investment advisers is not so much in picking stocks, but in keeping clients from impulsively trading at the wrong time. Maymin found that aggressive orders cost clients about 4% a year.

In other words, investors act against their own best economic interests with alarming regularity and cost themselves huge amounts of wealth in the process.

Dr. Casti says this is because society tends to form social groups based on affinity rather than simply becoming a collection of isolated individuals. That’s why investors tend to magnify the importance of information you see in the herd around you rather than breaking from it before it goes over the cliff.

When it comes to money, we see this in a phenomenon known as “chasing returns” or following the hot money. This is why annual performance issues like those published in Forbes, Money Magazine or Kiplinger’s, for example, are so irresistible. And so dangerous.

That brings me to fear.

The Only Thing We Have to Fear …

Right now millions of investors are sitting on the sidelines completely paralyzed by plain old-fashioned fear, and who can blame them? These markets have been some of the most vicious in recorded history.

Yet, I would argue that fear actually contributes to both recency and herding because it causes people to sit on cash that should be invested or keep money in the game when it should be taken to the sidelines.

Studies show that this comes down to pain. Losses hurt. They hurt financially and they hurt emotionally. Nobody likes them.

That’s why people are more likely to let a losing position go against them than take profits — because they can’t take the “pain” of being wrong. The fact that they are unprofitable becomes almost irrelevant.

I can attest to that, having helped hundreds of thousands of investors over the years through my columns, presentations and seminars worldwide. That’s why I do everything I can to enforce the discipline of taking profits and minimizing losses in careful concert with an overall plan.

By breaking the recency factor and eliminating the herding mentality that went with it, I find that many times fear is no longer an issue. So how do you break the habits that you didn’t know you had?

Here are three simple options:

1. Have a plan. Use the proprietary 50-40-10 structure allocation model[1] I pioneered. That way you can sleep well at night knowing that even if the markets pitch a hissy fit, your money is properly concentrated in a safety-first structure that’s high on income, stability and growth.
2. Take a measured approach. Dollar cost average into positions over time by splitting your money into chunks instead of investing it all at once. That way you’re investing a little at a time and can overcome the recency bias associated with big down days or bad news that rocks the markets. People usually look for patterns they can bet on, and averaging in removes this self-defeating tendency very deliberately and effectively.
3. Use trailing stops. Conventional wisdom tells you to sell your losers and let your winners run. I think that’s backwards. Nobody ever made money by selling losers. You have to periodically sell your winners without interference and trailing stops let you do that. Of course, you’ve got to trim your losses, too, so don’t get me wrong here. Most brokerage firms have online trading platforms that can do this automatically. If yours doesn’t, consider a simple, inexpensive service like www.tradestops.com[2].

In closing, there’s no denying that what happens tomorrow is a function of what happened to us yesterday. The question is how we harvest what we learn in the meantime.

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