What was I thinking?
If there's one question that investors have asked themselves over the past year and a half, it's that one. If only I had acted differently, they say. If only, if only, if only.
Yet here's the problem: While we know we made investment mistakes, and vow not to repeat them, most people have only the vaguest sense of what those mistakes were, or, more importantly, why they made them. Why did we think and feel and behave as we did? Why did we act in a way that today, in hindsight, seems so obviously stupid? Only by understanding the answers to these questions can we begin to improve our financial future.
This is where behavioral finance comes in. Most investors are intelligent people, neither irrational nor insane. But behavioral finance tells us we are also normal, with brains that are often full and emotions that are often overflowing. And that means we are normally smart at times and normally stupid at others.
The trick, therefore, is to learn to increase our ratio of smart behavior to stupid. And since we cannot (thank goodness) turn ourselves into computer-like people, we need to find tools to help us act smart even when our thinking and feelings tempt us to be stupid.
Let me give you one example. Investors tend to think about each stock we purchase in a vacuum, distinct from other stocks in our portfolio. We are happy to realize "paper" gains in each stock quickly, but procrastinate when it comes to realizing losses. Why? Because while regret over a paper loss stings, we can console ourselves in the hope that, in time, the stock will roar back into a gain.
By contrast, all hope would be extinguished if we sold the stock and realized our loss. We would feel the searing pain of regret. So we do pretty much anything to avoid that pain -- including holding on to the stock long after we should have sold it. Indeed, I've recently encountered an investor who procrastinated in realizing his losses on WorldCom stock until a letter from his broker informed him that the stock was worthless.
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Successful professional traders are subject to the same emotions as the rest of us. But they counter it in two ways. First, they know their weakness, placing them on guard against it. Second, they establish "sell disciplines" that force them to realize losses even when they know that the pain of regret is sure to follow.
So in what other ways do our misguided thoughts and feelings get in the way of successful investing -- not to mention increasing our stress levels? And what are the lessons we should learn, once we recognize those cognitive and emotional errors? Here are eight of them.
No. 1: Caring that Goldman Sachs is faster than you
There is an old story about two hikers who encounter a tiger. One says: There is no point in running because the tiger is faster than either of us. The other says: It is not about whether the tiger is faster than either of us. It is about whether I'm faster than you. And with that he runs away. The speed of the Goldman Sachses of the world has been boosted most recently by computerized high-frequency trading. Can you really outrun them?It is normal for us, the individual investors, to frame the market race as a race against the market. We hope to win by buying and selling investments at the right time. That doesn't seem so hard. But we are much too slow in our race with the Goldman Sachses.
So what does this mean in practical terms? The most obvious lesson is that individual investors should never enter a race against faster runners by trading frequently on every little bit of news (or rumors).
Instead, simply buy and hold a diversified portfolio. Banal? Yes. Obvious? Yes. Typically followed? Sadly, no. Too often cognitive errors and emotions get in our way.
No. 2: Thinking foresight can be as clear as hindsight
Wasn't it obvious in 2007 that financial institutions and financial markets were about to collapse? Well, it was not obvious to me, and it was probably not obvious to you, either. Hindsight error leads us to think that we could have seen in foresight what we see only in hindsight. And it makes us overconfident in our certainty about what's going to happen.Want to check the quality of your foresight? Write down in permanent ink your forecast of tomorrow's stock prices. Do that each day for a year and check the accuracy of your predictions. You are likely to find that your foresight is not nearly as good as your hindsight.
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Can you trust your financial adviser?As the market tanked, investors wondered where to put their money. Many are turning to advisers, but don't know how to choose the right one.
Some prognosticators say we are in a new bull market and others say this is only a bull bounce in a bear market. We will know in hindsight which prognostication was right, but we don't know it in foresight.
When I hear in my mind's ear a voice that says the stock market is sure to zoom or plunge, I activate my "noise-canceling" device rather than go online and trade. You might wish to install this device in your mind as well.
Continued: The pain of regret and the joy of pride
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I look at the business, not the market. First I do a quick test to determine if the last 10 years of Return on Shareholders Equity, projected forward 10 years can be discounted to a present value that will net me at least 20%. This is a margin of safety. Also, having a 40% or more of gross/profit margin or above is excellent. The next quick intermediate step is to see how the company is making money--has it had 10 good years of earnings and dividends, is not encumbered by long term debt, R&D, Depreciation/Amortization, etc. If the stock still looks enticing, it is time to go through all the entries on the three financial statements to see how the company is making it's money--is it selling goods and services to profit or is it is using other means to construct its' underlying financial structure. The economy is not strong now! Economic indicators like the Employment Situation Report, ISM Report-Manufacturing, Weekly Claims for Unemployment, Consumer and Producer CPI, etc. show, on the whole, a more dismal condition than this time last year. If people don't have money to spend, how can the Big Three markets all go up at least 10% in the last three months? I am having a wonderful time picking stocks that are truly undervalued. Now it seems the time that the cycle begins again--buyers start buying stocks because they are figuratively foaming at the month to increase their holdings and to regain their losses. Buy cheap, sell dear, for no one knows when the Bear will be thrashing or the Bull will be charging. 