Investing: How Could We Behave That Way?

To varying degrees, the average investor earns significantly less than mutual fund performance reports would suggest.

By Mark B. Robinson

Studies that measure the effects of investors decisions to buy, sell or switch into or out of mutual funds have shown to varying degrees, that the average investor earns significantly less than mutual fund performance reports would suggest.

Is there a problem here? Yes, but as Charles D. Ellis observed, the problem is not in the market but in ourselves, our perceptions and our reactions to our perceptions. In other words, we confound ourselves through behavior we tend to repeat again and again. For example

We typically give too much weight to recent experience and extrapolate recent trends that are at odds with long-run market averages and statistical odds. For example in 1998 and 1999, expecting Large Cap Growth funds to continue to return in excess of 25% annual returns in 2000. And in 2002, swearing-off stocks completely.

We tend to become overly-optimistic when the market goes up. This often causes us to become too aggressive and buy on tips, chase hot stocks, mutual funds and sectors – regardless of price.

We tend to become overly-pessimistic when the market goes down. This often causes us to sell low and become too conservative in our portfolio. This can jeopardize our long-term goal of accumulating sufficient assets to sustain us during retirement.

We often see order or a trend where it does not exist. Market timing i.e., trying to time when to be in the market and when to be out of the market is a good example. Randomness can often look like a pattern, so be careful with stock-picking gimmicks, too.

We often make knee-jerk decisions or act on sound bites rather than gathering data from several independent sources. It is rarely in your better interest to make a quick decision, and you should not rely on one source for information – especially if the source has entertainment value e.g., market-related shows on cable.

We are overconfident in their own abilities – especially in areas where we have some knowledge – and attribute our accidental success to skill. This often leads to concentrated positions in one or two stocks or buying only in one particular sector.

We don't like to admit their mistakes and recognize a loss. But there is an additional cost in holding on to losing positions. It is called "opportunity cost." The cost of not being invested where opportunity exists to realize gains.

Managing our investments is difficult enough. We don't need compound this through our behavior. Being aware of these common behavioral mistakes -- and when they may be showing up in your thought process -- may hopefully cause you to reconsider your actions and in doing so, increase your probability of achieving your long-term investment objectives.

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This material is not intended to replace the advice of a qualified tax adviser, attorney, accountant and/or insurance adviser. You should consult with the appropriate professional before you make any financial commitment regarding the issues related to your situation. These projections and examples are hypothetical and do not reflect actual investment results and are not a guarantee of future results.

Mark B. Robinson is a presenter for the Investor Education in Your Community program, a series of nonprofit, non-commercial financial literacy seminars held at public libraries.

The Investor Education in Your Community program paid for placement of this article. Its views do not necessarily reflect those of WWJ Newsradio 950 or CBS Radio.

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