Achieving
Investment Goals
by John P. Ciccone, ChFC, CFS, TEP
The Wealth Navigation Team
"The investor's worst enemy is likely to be himself." Benjamin Graham, a legendary value investor and one of the fathers of modern security analysis.
Achieving Investment Goals
An
expanding field known as behavioral finance is beginning to take
hold which demonstrates that psychology plays a significant role
in how investors make decisions. Historically, the impact of
psychology and how it relates to decision-making has been mostly
ignored. Studies by Richard Thaler of The University of Chicago
and Daniel Kahneman of Princeton clearly demonstrate that investors
behave highly irrationally and make predictable errors. These
investment errors can wreck havoc on an investment portfolio
and upon the investor's ability to achieve long-term financial
goals.
Outlined below are
three of the key "psychological biases", including
overconfidence, availability bias and mental accounting;
which affect the investment decision-making process along with
practical strategies to help you avoid making decisions based
upon a "psychological bias" so that you can achieve
greater investment success.
Overconfidence
Psychologists
have found that people become overconfident when they experience
success. i There
are two main sources of overconfidence bias. The first relates
to the fact that most people consider themselves to be better
than average in most things they do. For example, 80% of drivers
contend that they are better than "average" drivers.
ii Is
that really possible?
The second source of
overconfidence is due to people's tendency to "underestimate"
the role of chance in events and erroneously attribute their
skill as the defining factor for achieving success. This overconfidence
was clearly illustrated in the late 1990's where even novice
investors experienced exceptional growth in technology stocks.
As the technology stocks continued to soar, investors began to
attribute much of their success to their ability to make wise
investment decisions rather than attributing their success to
the unsustainable growth in one sector of the economy. Unfortunately,
for many investors, this overconfidence leads to significant
financial loss.
Avoiding Overconfidence
Let history be your guide and keep things in perspective. The late 1990's weren't the first time that people got caught up in investment "mania", only to watch the speculative bubble burst and suffer significant losses. It also happened with the railroads in the early 1900's, radio broadcasting in the 1920's, as well as oil and gold stocks in the early 1980's. In each case, investors thought; "This time is different, it's a new economy." When the next investment mania occurs, keep things in perspective and ask yourself, "Is history repeating itself?"
Establish an investment policy statement. An investment policy statement determines what percentage you will invest in asset classes such as stocks, bonds, and cash. For example, based on your risk tolerance, you may determine that 60% of your assets should be in stocks, 30% in bonds and 10% in cash. Assuming each category is diversified, studies have demonstrated that you can expect a certain range of returns and volatility over the long-term based upon your allocation. Establishing and monitoring the above parameters can help you limit your emotional involvement and avoid the overconfidence bias. When the market surges ahead, and your confidence increases, check your investment policy statement to make sure you stay on course.
Availability Bias
Availability
bias causes people to base their decisions on the most recent
and meaningful events. The brain views ancient history as anything
that happened more than a couple of years ago. For example, if
you were in a car accident within the last week, it would be
a natural tendency for you to drive extra cautiously for the
next month. However, as time passes, your driving will likely
return to its original state. Availability bias causes investors
to over-react to market conditions whether it be "positive"
or "negative". As illustrated earlier, in the late
1990's, investors got caught up in tech mania, which caused them
to disregard the risks. This was followed more recently by troubling
events in the economy, which caused investors to lose confidence
and over-focus on the short term, negative results. It is natural
for people to get lost in the moment. Availability bias also
causes people to think that events that receive heavy media attention
are more important and pertinent than they are in actuality.
Unfortunately, much of the financial information received on
a daily basis is mostly noise and not particularly important.
In fact, the information is often inaccurate, based on multiple
opinions, outdated or downright confusing. Coupled with too much
information, many investors overlook the fact that they often
lack the training, experience and objectivity to interpret the
massive amount of information available. This causes many investors
to get a false sense of security in thinking they are well-informed
investors.
James J. Cramer, analyst
for CNBC Network's morning show "Squawk Box" and co-founder
of the magazine Smart Money, loosely advised audiences not to
watch too much CNBC or read too much of the popular financial
press because many people who appear are scripted and don't give
enough information to form a basis for real analysis. "It
is ironic that the greatest stock bubble coincided with the greatest
amount of information available. I always thought this would
be a good thing, but maybe it was not so good," notes Cramer.
iii
Avoiding Availability Bias
Focus
on long-term results and avoid getting swept away by your emotions
and the latest mania whether it be positive or negative.
Recognize that it is
a human tendency to overemphasize the most recent financial events
proliferated by the news media. Simply refuse to let those events
overly influence you. The old axiom, "nothing is as good
or as bad as it seems" is important for the investor to
keep in mind.
Mental Accounting
What
behavioral finance professionals have called "mental accounting"
is where investors mentally compartmentalize money such as individual
stocks, bonds, real estate or cash. This causes investors to
lose sight of the big picture and instead focus on each specific
investment and feel pleasure or pain depending on a particular
investment's performance.
For example, an investor
may purchase a specific stock or mutual fund, which declines
in value 10% over 12 months. Because of the tendency to think
myopically (mental accounting), the investor tends to feel a
disproportionate amount of pain from the loss. The investor may
overlook the fact that his overall wealth (stocks, bonds, real
estate and cash) has actually increased over the same period.
While investors recognize that certain asset classes will outperform
others during any given period, due to mental accounting, an
investor will typically hyper-focus on the investments that are
down. Furthermore, the results of psychological studies indicate
that investors feel the pain of loss 3 times greater than the
pleasure of gain. This pain can cause an investor to make highly
irrational decisions such as selling their stocks during a down
market. This investor not only suffers the loss of selling at
a low, but may also miss a substantial upturn.
How to
Avoid
Mental Accounting
Measure
your investment success by the performance of your overall assets
versus measuring success by a particular asset category such
as stocks, bonds, or real estate. Remember, it is your overall
financial picture that matters at the end of the day, not how
one asset category has done.
Establish long-term
financial goals. Acknowledge to yourself that the fluctuation
of your investments along the way does not determine your ultimate
success or failure. It is the eventual safe arrival at your destination
that is most important.
Conclusion
It
is increasingly more apparent, if inventors are to achieve optimal
returns, they cannot afford to overlook the role that psychology
plays in the decision-making process. Recognizing that psychological
biases exist and taking proactive steps to overcome them will
undoubtedly increase the investor's ability to achieve their
long-term financial goals.
Editor's Note: John
Ciccone, ChFC, CFS, TEP, Independent Financial Advisor and founder
of The Wealth Navigation Plan, has specialized in comprehensive
financial consulting for over 15 years. Working with closely
held business owners, John Ciccone found that business owners
confront unique dangers and opportunities and therefore require
customized planning to achieve their goals. In response to this
need, he developed The Wealth Navigation Plan. Affiliated with
Capital Analysts of New England, Inc., The Wealth Navigation
Team offers highly skilled legal, accounting, tax, insurance
and investment professionals who blend technical expertise and
creativity to solve sophisticated financial problems. John Ciccone
and The Wealth Navigation Team are located at 1266 Furnace Brook
Parkway, Quincy, MA. For more information contact (617) 786-1600.)
i Paul Presson and Victor Benassi, 1996, "Illusion of Control" Journal of Social Behavior and Personality 11(3): 493-510.
ii John R. Nofsinger, Investment Madness (New York : Prentice Hall, 2001) 13.
iii Wharton School of University
of Pennsylvania Web site, www.knowledge.Wharton.upenn.edu/articles.
1 Paul Presson and Victor Benassi, 1996, "Illusion of Control" Journal of Social Behavior and Personality 11(3): 493-510.
2 John R. Nofsinger, Investment Madness (New York : Prentice Hall, 2001) 13.
3 Wharton School of University of Pennsylvania Web site, http://knowledge.Wharton.upenn.edu/articles.
