How To Avoid Destructive Investment Behavior

Of all the obstacles investors face, our own behavior patterns are unquestionably the biggest.

Behavior includes things like bias, misconception, and making the same mental mistakes repeatedly, even though we know better. We all make mistakes, and we make a concerted effort to learn from them. When things go wrong with a position, we ask ourselves why. We adjust our behavior so that we won’t repeat the same mistake the next time a similar situation presents itself. Great investors are constantly learning from their mistakes and adapting.

But some mistakes are harder than others to correct. Studies have been done by economists and psychologists to try and determine what kind of mistakes investors make most often, and why they make them. The list is long, and this article isn’t intended to cover all of them. But to give you an idea of what we teach about behavior, here’s a list of questions we use with coaching clients. Ask yourself these questions and see whether any of these behaviors may apply to you.

Do you ever resist selling a stock that’s down a lot, with the intention of waiting until it gets back to your purchase price? Behavioral economists have a name for this – “get-even-itis.” Most skilled investors are quick to sell a losing position and put those funds into a name with better prospects. Use a mental stop, and stick to it.

Do you ever put off buying a stock that you like, just because it’s been going up the past few days and you want to buy it cheaper? It’s o.k. to have a limit price in mind, but don’t be too stubborn if the stock is beginning to take off. Consider buying half now and waiting for a correction to buy the other half.

Do you believe that you can find companies where the returns will be large and the risks will be small? They’re out there, but it takes time, effort, and research to find them. They don’t grow on trees.

Have you thought about what would happen to your portfolio returns if you were to suddenly need to take out a large chunk of money for an unexpected event? Skilled investors plan ahead for this and carve out an emergency fund. They make it part of their investment plan.

Do you have specific goals in mind for each investment account that you have? College savings; high current income; high growth; value, etc.? Make it part of your investment plan.

Do you know how much risk you’re taking with each of your accounts? You can take more risk with long-term accounts, and less with short-term ones. The Sharpe Ratio is a good way to measure your risk in each account.

Do you have a source for stock ideas that consistently beats the market? Be careful because hot hands often become cold. Go for those with long-term success (10 years minimum).

How do you think you rate as an investor, compared to the average of all investors? If you think you’re better than most, you might be suffering from Hubris, which is a return killer.

If you buy a stock today and it immediately declines in value, are you more likely to buy more? sell? hold on? Work these things out before you make the trade, with specific price parameters.

When a stock that you own goes down a lot due to bad news, how do you generally react? Trailing stops can help, whether mental or actual.

Do you know how you did in the market last year? How about the year before that? Keeping track of your results is important. It can tell you whether your strategy needs to change.

Which is more important to you, beating the market or avoiding big losses? Beating the market isn’t a practical goal, but avoiding large losses is the key to long-term success.

When you need to withdraw money from your account, are you more likely to sell a winning position or a losing position? It’s almost always better to sell your losers first and let your winners run.

By going through the exercise of asking yourself these questions, you may find that there are some areas of investing that you need to work on a little more. When it comes to how well you did last year and the year before, you might be surprised to find a big difference between your perception and the facts. Write down your answer, and then take a look at your statements to find out how close you are to the truth.

[The image for this article is courtesy of Walt Kelly.]