Stop Making Investment Mistakes

It was when I found out I could make mistakes that I knew I was on to something. —Ornette Coleman

Not Quite a 12-Step Program

We all make mistakes and, as with every hangover, we emphatically and fruitlessly vow never to do it again. But I promise that you will. The end.

Just kidding.

Innate human tendencies were meant to help us survive the wilderness, not make investment decisions. And yet, those are the tools we rely on today for complicated reasoning. No wonder investing hasn't been seamless. Not totally wrong, but not totally right either. Recognition and acknowledgement are the first steps in any 12-step program for change. You don't know what you don't know, and if you aren't aware in the first place, you can't make a decision to affect change. If you soberly knew a way to make intelligent investment decisions, you would. If it only took a bit of understanding to be more profitable, you'd do that too.

This is not a book telling you to spend less and save more, but one that provides all smart things to do while you are saving and once you have a nest egg. Whether you read it cover to cover or you select individual sections that will help you when you need them most, I hope you will keep a well-worn copy next to your investment account statements.

Play it Again, Sam

Both men and women harbour cognitive biases that influence our behaviour. The way each of us reacts is alarmingly predictable and consistent. Predictable and consistent. The good news is that you're not alone. The propensity to make errors with money and investing is well documented through a growing body of study called behavioural finance.

Luckily, cognitive biases are nothing more than tricks and shortcuts that our brains use to help us make quick decisions and be more efficient in our lives. Unfortunately, these pre-fab decision trees don't necessarily add value to the financial outcomes at hand.

The plight of the human condition leaves no one behind. Over the years, these biases have taken hold regardless of race, education, gender or socioeconomic status. Decision errors are made and repeated with great regularity. Rational financial decisions are much easier to make once you understand the reasoning behind these biases and are able to recognize the predispositions. If you're already entrenched in the belief that each of us operates as a free decision maker, you won't need convincing that experience is the sum of mistakes that we don't need to repeat. Ultimately, it would be ideal to enhance your financial situation with the least amount of effort on your part. To do that, we need to lay out some groundwork.

Possibly the most important piece to understand is the notion that investment markets are efficient. This idea gained popularity in the 1950s. To be brief, the efficient market hypothesis maintains that stock market prices are random and fair. Essentially, it contends that there are enough rational people buying and selling stocks and other securities that the market will determine a fair price simply through the buying and selling of the securities. If the price are too high, no rational person would buy. If it's too low, no one would sell.

When stock prices get out of whack, sellers eagerly dump overpriced securities, driving prices down, and buyers then snap up underpriced ones with earnest, forcing fair values. Imagine a passerby frantically rapping on your door, offering to purchase the gargoyle peering over your eaves for twice what you bought it for. You'd be a fool not to sell it. The passerby must have different information about the value of the statue of course, or she rationally would not purchase the ugly beast against her financial best interest. If there were a crowd outside your home, some selling gargoyles and some buying, you could reasonably assume that the average agreeable price of the transactions represents a fair market value for the statues.

The second part of the efficient market hypothesis (you'll have a few great phrases to throw around the coffee shop by the last chapter!) is that the prices of stocks and bonds reflect all information that buyers and sellers have. For example, when a company announces its earnings, the investing public analyzes the new information (very quickly!) to determine the fair market value of the shares. Assume that the company's reported earnings came in lower than expected. Obviously, investors who value the share price relative to the earnings would sell the shares at current levels. You'd be as much a fool as the homeowner with the gargoyle not to. In turn, the sheer interest in selling the shares at the inflated levels and the diminished interest in buying the relatively high priced shares drives the share prices lower on the market. Once the shares are at the fair market value, the opportunity to profit on the difference no longer exists.

This oversimplification is to illustrate what drives market prices up or down. In practice, there are multiple facets affecting the perceived value of any stock, bond or gargoyle, much of which is disputed among market participants. For every transaction, there's someone willing to buy and someone willing to sell at an agreed price, both believing that it's good value and that the counterparty is a little crazy. That's what's fun about this. The differences of opinion are what keep markets humming and prices continually adjusting to find the fair value. It's been said that it's only a fair trade when both parties consider the other to have received the better deal.

In real life, it's more complicated than just analyzing new earnings information every 3 months. Consider the influences of global economic growth, new competitors, interest rates and changes in the price of supplies or wages that can fluctuate minute by minute. Beyond the hard data, subjective factors equally influence the prices of everything. The complexity of analysis is as thick and deep as there are opinions. There are at least two opposing viewpoints every time a transaction happens. Sometimes a stock will trade at a price that is 10 times the value of the earnings per share and sometimes at a price that is 16 times. It's the aggregate opinion that determines who is right and who is less right.

At first glance, the theory makes sense, but what the efficient market hypothesis doesn't account for is the fact that people are not always rational. Just ask any divorce lawyer. Despite this fissure, the theory's premise doesn't need to be thrown out with the bathwater. It's a reminder that we do not operate like machines. You can't simply install an update to fix a programming bug.

Since people are at the helm of these trading decisions, the market itself is subject to collective human errors. This notion can be extrapolated to entire economies. In general, economic cycles are built on stages of cumulative human errors. When people collectively feel exuberant or fearful, or they do something in concert the way a cohort (like the baby boomers) might, the economy follows. When everyday folks feel wealthy as their bonus rolls in higher than expected, their annual house assessment jumps, their RRSP statement climbs again this month or their high-flier stock doubles, jubilance spills over into spending habits. If the majority of people feel this way and behave this way, the economy expands or continues expanding.

I trust that you've already made the leap to see that the reverse is also true. When you hear nothing but solemn news reports of financial collapse and economic deterioration, or the value of your RRSP has been chopped in half and you can't sell your real estate, people naturally start reigning in spending. With all that depressing news, who feels like a shopping spree anyway?

The cycle of optimism and euphoria leads to greed, fear and capitulation, giving way to hope and building back to optimism. It drives the expansion and contraction of our financial world in a market cycle of collective human emotion.

Your actions and your neighbours' actions send a ripple effect throughout your community, city and province, compounding the issue. If you own a business, you may find yourself cutting costs, reducing marketing efforts and inventories, and possibly laying off staff. And so, we have market cycles driven by waves of human behaviour, some of which is rational and some of which is emotional.

Takes One to Know One

The following illustrations set out several common cognitive biases that have been working against you all of these years and the reasons that our hardwiring is naturally and irrationally applied to how we look at money. The reasons for why your attempts haven't worked in the past are not shocking. Simply by being aware of where the trouble lies and understanding some very interesting and goofy things that people do consistently, you suddenly become able to approach money differently than you have in the past. By realizing what can go wrong, you are in a position to impact your financial successes.

Hindsight is Not Foresight

Of course, anybody could have predicted the collapse of the fourth-largest U.S. investment bank, Lehman Brothers, which reported assets of $635 billion when it filed for bankruptcy protection, and Merrill Lynch & Co. agreed to be sold to Bank of America Corp. a week after the U.S. government bailed out other major U.S. financial institutions, on September 10, 2008. Mollenkamp, C. et all. (2008, Sept. 16). Lehman Files for Bankruptcy, Merrill Sold, AIG Seeks Cash. Wall Street Journal. Weren't your assets all cashed in before that happened? Your financial advisor must have known that it was going to happen! Why didn't he sell out your account beforehand? Or at least once the bankruptcy was announced?

The truth is that no one knows until they know. Once they know, so does everyone else. (If I start sounding too much like Dr. Seuss, just kick me under the table.)

With the speed of information today, share prices are affected almost immediately. Moreover, the initial correction is often overdone. When dramatic news is first released, there is often an overreaction resulting in a sell-off that may be more than warranted. In this case, the price drop is followed by a rebound as cooler heads prevail. If you want to see how accurate your foresight is, there's a simple way to find out. I told you this was going to be easy, didn't I?

Grab a small piece of paper and pen or pencil. Write down the closing value of the Canadian stock market index (S&P/TSX) for this Friday. You can find today's value by visiting www.tmx.com.

Simple!

Over a short period of time, surely you can tell where the market is going. If you don't know by how much, you'll at least know the direction with some certainty! (Note the sarcasm.)

Ah, but you're not a professional, you say.

Interestingly, Chartered Financial Analyst® societies all over the globe hold an annual Forecast Dinner. I've been involved with these events in Kelowna, B.C., as a board member since 2003. Every year, pre-eminent investment professionals are invited from all over North America to our little community of 125,000 people. They are asked to foretell the level of the S&P/TSX, the Dow Jones Industrial Average (DJIA), a long stock and a short stock (which we will cover in chapter 2) on the upcoming December 31. The following year they're invited back to defend their predictions in a roast format usually reserved for comedians or retiring guests of honour. It's an obviously impossible task for the incumbents and a great deal of fun for everyone else.

Instead of using your intuition about the direction of the market, step back, take a deep breath and dust off your good ol' Investment Policy Statement (IPS) that you wrote in more sober times. An IPS is a document that you will hear much about over the pages ahead, outlining how your investment decisions will unfold. If you haven't done so yet, there are wagers out that you'll have something in writing before you finish the last chapter. Realize that your appetite for risk (a.k.a. volatility) will change during different market conditions so it's important to write your IPS during times of stability in your life, when no major changes are on the table and when markets are relatively steady. Then stick to it.

The details of an IPS is explained in detail in chapter 9, dedicated to establishing one, why and what it contains. In the meantime, it's suffice to say that when markets become volatile, emotions often get in the way of a good plan. Treat them as lagging indicators. A lagging indicator is something that tells you what is going to happen after it already happened. Ironically, not kidding.

"Rebalancing and Investment Policy Statements—that is the key: IPSs written in calmer, rational times which dictate the frequency and timing of rebalancing is paramount. Buying equities after a major market decline is often the toughest exercise for retail clients but inevitably is the best thing to do. Having an IPS that you review annually with your Investment Professional is a crucial document. Sign and date this together to make it `official.' Humans have an innate tendency to have their actions match their words. What actions will I take if the market declines by 20%? Figure this out before it happens." —John Stubbs, Director, Wealth Management, Richardson GMP Ltd.

IPSs work. Write what you believe and how you wish to invest in black and white. Revisit it often.

Like shampoo instructions: lather, rinse and repeat.

Unleashing the Dogs

I love my family, but sometimes, personal relationships get in the way of asserting professional philosophies. When my father insists on holding a stock position, who am I to say no?

I now practice discretionary portfolio management for a bucket full of reasons, but a main motivation is to eliminate entry-level biases. Having discretion means that in addition to saving people from their biases and emotions, I can act quickly and efficiently during times of volatility. Instead of calling each client to convince them of the current course of action, I'm able to pull the switch and act in accordance with their IPSs and the prevailing market conditions.

A 'dog' is a beloved term used to describe a bad investment, as in, "this portfolio has gone to the dogs." It's an alarmingly common belief that if you don't sell anything that is down, you aren't really losing money! While this logic is rewarded when you own good quality, suitable investments during temporary drops in the overall market, it's never rewarded when you hold onto a bad investment that continues to drop in value or one that has no hope of recompensing you. Trying to convince someone who grips this notion with white knuckles and the strength of an army is like blowing out an electric light bulb. No one is better for the effort. If an investor only sells the stocks that appreciate in value and refuses to sell those that drop, eventually the investor has nothing left but a portfolio dogs. I've seen these beauties.

Behavioural finance researchers have also labeled this problem. Anchoring is when you assign a value to something based on information that is irrelevant or even random. Prudent investors build decisions on whether to buy, hold or sell a security based on the relevant economic information, their investment objectives and suitability of the position within those parameters. Past information and irrelevant facts, including a historic price for the security, are not part of the process. With the error of anchoring, people have an inclination to consider either the price paid for an investment in the past, the price at which it peaked (regretting not selling it) or some other irrelevant information. These are powerful motivators to keep the stock for completely irrational reasons.

"There is nothing more destructive to a portfolio than allowing deteriorating companies to grow into outsized losses. Have the fortitude to admit mistakes early, move on and reallocate your capital to better investments. Be able to also recognize when your biggest winners have run their course and despite still being great companies are no longer great investments. Simply, have a well-defined sell discipline and follow it. It's the difference between having a successful investment strategy and one that is not." —Clark Linton, CFA, Portfolio Manager, Raymond James Ltd.

If you're still not convinced, just remember that it never matters what you paid for an investment. If it no longer fits your investment strategy, it has deteriorated in quality or there are better opportunities for that capital, forward-looking investors will sell. Period. Whether it's up, down or equal to the price originally paid should never be a determining factor in whether to continue owning an investment. Your original investment price only matters when you're calculating the tax on the investment. Nothing more.