The 5 Deadly Sins of Investing

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The 5 Deadly Sins of Investing
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By Daniel Solin

If you invested dispassionately, using an objective analysis of the historical data, you would invest in a globally diversified portfolio of index funds with low management fees. It's not that you can't beat the market by investing in actively managed funds. Every year, some mutual funds outperform their benchmark. However, their probability of doing so over the long term is relatively low. Over a 20-year period, about 80 percent of actively managed funds will underperform their benchmark, Charles Ellis wrote in a 2012 article published in Financial Analysts Journal.

It gets worse. If you make the wrong pick and your fund underperforms, the underperformance is likely to be significantly greater than the outperformance of the minority of funds that beat their benchmark.

You would expect professional or "institutional" investors to have a better track record of beating the market, but they don't. The same research from Charles Ellis on institutional portfolios found that only 1 percent of the funds they chose "achieve superior results after costs."

It may seem that individual and institutional investors are acting irrationally by chasing returns, but that would be incorrect. %VIRTUAL-article-sponsoredlinks%The study of behavioral finance attempts to explain this conduct by introducing psychological factors that may play an important role in investing decisions. If you want to understand what drives you to ignore the data and engage in conduct likely to reduce your returns over time, you need to understand how your emotions may overcome your ability to objectively view critical data. Here's a summary of the most common biases:

1. Anchoring. Anchoring describes the tendency to focus on one factor when making decisions, while ignoring other factors that may be of equal or greater importance. Examples of anchoring in investing abound, stimulated largely by the financial media. References to stocks being "overbought" or "oversold" are examples of anchoring. These factors may or may not be logically related to the future price of the stock.

2. Overconfidence. In my experience, overconfidence is the trait that probably does the most harm to investors. When gold was at its peak in September 2011, one of my clients at the time instructed me to sell her diversified portfolio, closed her account and opened a new one with a broker specializing in gold. She told me it was "obvious" we were on the brink of an international depression, and gold was the only safe haven.

Unfortunately, when the subject is investing, many people believe they are experts, even though most have no training in finance. Their overconfidence often causes them to make unwise investing decisions. There is also evidence that men are more prone to overconfidence than women, according to a 2001 research paper by Brad Barber and Terrance Odean named "Boys Will Be Boys: Gender, Overconfidence and Common Stock Investment."

3. Hindsight Bias. Hindsight bias refers to our tendency to take facts now known and interpret them in a way that explains past events. This is a particularly dangerous bias because it causes us to believe we have more control over the future, due to our belief that we can explain the past.

Many clients tell me the 2008 financial recession was inevitable, yet few predicted it at the time and took action to protect themselves from the market crash. Undeterred, these same investors now have strong opinions on the future direction of the markets, even though tomorrow's news will play a significant role in determining stock prices, and no one knows what that news will be.

4. Representativeness. Investing is complicated. There is a human tendency to look for shortcuts, instead of sifting through all the variables, by placing undue emphasis on one or two qualities and filtering all information through those categories. For example, if a particular asset class has performed well or poorly recently, you may be inclined to categorize information about a stock and put it into the category of a "strong" or "weak" performer, even if there are many other issues you should be considering.

5. Herd Behavior. Herd behavior occurs when investors follow the behavior of a larger group, even in situations in which it may be difficult to rationally justify the decisions of the group. A classic example of herd behavior occurred in the 1990s. Investors poured huge assets into the stocks of fledgling Internet companies, even though many of them didn't have any profits and were unlikely to generate significant revenues in the foreseeable future.

There are many adverse consequences of herd behavior. They include high transaction costs, which happens when everyone tries to keep pace with the latest hot trends. Focusing on the conduct of the herd, instead of fundamentals that are more relevant considerations, will likely result in disappointing returns.

Understanding the role that behavioral finance plays in your investing decisions is a critical first step. Many investors don't realize they are engaging in these biases, much less appreciate how they inhibit intelligent, responsible and evidence-based investing choices. All investments carry an element of risk, but you can become a better investor if you are aware of these powerful forces that operate in your subconsciousness.

Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth adviser with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His next book, "The Smartest Sales Book You'll Ever Read," will be published March 3.

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The 5 Deadly Sins of Investing

Warren Buffett is a great investor, but what makes him rich is that he's been a great investor for two thirds of a century. Of his current $60 billion net worth, $59.7 billion was added after his 50th birthday, and $57 billion came after his 60th. If Buffett started saving in his 30s and retired in his 60s, you would have never heard of him. His secret is time.

Most people don't start saving in meaningful amounts until a decade or two before retirement, which severely limits the power of compounding. That's unfortunate, and there's no way to fix it retroactively. It's a good reminder of how important it is to teach young people to start saving as soon as possible.

Future market returns will equal the dividend yield + earnings growth +/- change in the earnings multiple (valuations). That's really all there is to it.

The dividend yield we know: It's currently 2%. A reasonable guess of future earnings growth is 5% a year. What about the change in earnings multiples? That's totally unknowable.

Earnings multiples reflect people's feelings about the future. And there's just no way to know what people are going to think about the future in the future. How could you?

If someone said, "I think most people will be in a 10% better mood in the year 2023," we'd call them delusional. When someone does the same thing by projecting 10-year market returns, we call them analysts.

Someone who bought a low-cost S&P 500 index fund in 2003 earned a 97% return by the end of 2012. That's great! And they didn't need to know a thing about portfolio management, technical analysis, or suffer through a single segment of "The Lighting Round."

Meanwhile, the average equity market neutral fancy-pants hedge fund lost 4.7% of its value over the same period, according to data from Dow Jones Credit Suisse Hedge Fund Indices. The average long-short equity hedge fund produced a 96% total return -- still short of an index fund.

Investing is not like a computer: Simple and basic can be more powerful than complex and cutting-edge. And it's not like golf: The spectators have a pretty good chance of humbling the pros.

Most investors understand that stocks produce superior long-term returns, but at the cost of higher volatility. Yet every time -- every single time -- there's even a hint of volatility, the same cry is heard from the investing public: "What is going on?!"

Nine times out of ten, the correct answer is the same: Nothing is going on. This is just what stocks do.

Since 1900 the S&P 500 (^GSPC) has returned about 6% per year, but the average difference between any year's highest close and lowest close is 23%. Remember this the next time someone tries to explain why the market is up or down by a few percentage points. They are basically trying to explain why summer came after spring.

Someone once asked J.P. Morgan what the market will do. "It will fluctuate," he allegedly said. Truer words have never been spoken.

The vast majority of financial products are sold by people whose only interest in your wealth is the amount of fees they can sucker you out of.

You need no experience, credentials, or even common sense to be a financial pundit. Sadly, the louder and more bombastic a pundit is, the more attention he'll receive, even though it makes him more likely to be wrong.

This is perhaps the most important theory in finance. Until it is understood you stand a high chance of being bamboozled and misled at every corner.

"Everything else is cream cheese."
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