Your Investor Blind Spots

Richard L. Peterson, Frank F. Murtha

• Publisher: Wiley
• Year: 2011
• Print ISBN: 9781118108345
• eBook ISBN: 9781118006368
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

Most investors who fail to reach their goals do so because they fall into identifiable and often predictable mental pitfalls along the way. They already exist in our psyches, and they do their damage before we are aware of their presence. Every investor has weaknesses and vulnerabilities. These make up the darker side of our investor identity. And though some are more at risk than others, these investor traps are universal human tendencies to which every investor is susceptible. Forging a more effective investor identity involves not only recognizing these traps, but also realizing your personal susceptibilities to them and developing the ability to sidestep them along the way to your goals.

This chapter describes the most common and insidious investor traps. You will learn to identify and minimize the impact of these common mental mistakes.

CHAPTER 6

Your Investor Blind Spots: Identifying (and Avoiding) Mental Traps

Most investors who fail to reach their goals do so because they fall into identifiable and often predictable mental pitfalls along the way. If there were signs that said “ Warning: Mental Pitfall Ahead! ” there would be no problem. But such traps catch us offguard precisely because they lurk in our blind spots. They already exist in our psyches, and they do their damage before we are aware of their presence.

Every investor has weaknesses and vulnerabilities. These make up the darker side of our investor identity. And though some are more at risk than others, these investor traps are universal human tendencies to which every investor is susceptible.

Forging a more effective investor identity involves not only recognizing these traps, but also realizing your personal susceptibilities to them and developing the ability to sidestep them along the way to your goals.

This chapter describes the most common and insidious investor traps. You will learn to identify and minimize the impact of these common mental mistakes.

Trap #1: Win/Lose Mentality

Most investors love to keep score, and there is no bigger, clearer scoreboard than that provided by stock markets. Our personal score cards are delivered in the form of monthly statements, but we no longer need to wait a week to get the final numbers. With Internet access, we can see how we’re doing at any given moment of any given day. A gain on the day is translated as a win, while a loss gets classified as just that, a loss. Investors easily slip into such a win/lose, binary framework for evaluating their financial returns status.

Thinking in terms of numerical profits and losses leads to immediate emotional reactions whenever you get feedback about your gains and losses, which increases your overall stress level. Most people want to relieve short-term emotional pressure, especially the negative kind, even at the expense of long-term wealth accumulation. The win/lose mentality is a mental trap that increases stress and encourages a short-term, money-focused, and outcome-oriented frame of mind.

A win/lose mentality is appropriate in many settings. NFL football comes to mind. An NFL team plays 16 games during a season. Each game has a binary outcome: “ win ” or “lose” (I’m not counting ties here; they’re fairly rare). It doesn’t matter if you win a game by 30 points or on a last-second field goal. The resulting win has the same significance. The same reasoning applies to losses. If a team has enough wins at the end of the year, they qualify for the playoffs. At the playoffs, another series of binary outcomes will determine whether that team becomes the Super Bowl champion—the ultimate goal.

But what happens when you apply win/lose logic to investments? It is easy for investors to be drawn into a perspective that views individual holdings as games in the “ investing football season. ” Holdings that yield a profit get mentally filed in the “ W column, ” while those that take a loss go in the “ L column. ” This is not only unsound, it ’ s dangerous. For one thing, all wins and losses are not created equal. The first factor is how much money you have invested; the second is the percentage of the price movement. For example, a 10 percent loss in a $10,000 holding is clearly not evened out by a 10 percent gain in a $5,000 holding (you would need a 20 percent gain for that). Nonetheless it’s a convenient mental shortcut to slap win/lose labels on our investments.

Even when you look at the total profit or loss of your portfolio, the win/loss framework remains a trap. You may have long-term financial goals, but it would be a mistake to approach them as win/lose (e.g., “ $2,000,000 or bust!”). Another way investors keep score is by performance per time period . This week was a winning week. This month was a losing month. Last year was a losing year.

But introducing the notion of investing “quarters” creates the feeling of the ticking clock, and time pressure does awful things to our decision making.

You may hear a little voice in the back of your head whisper, “How are you going to make up for that loss? You have to make money now! Time is running out!” But the clock is not going to “run out,” not the way it does in football. In an NFL game the need to take a big gamble may make perfect sense—it can be your only hope to win the game. But being baited into taking a big risk with your investments in order to make back lost money is never a good idea. In football these desperation heaves are called “Hail Marys.” In investing they are called, well, “Hail Marys.”

Another problem born of this win/lose framework is that in our effort to score a win (and consequently feel good about ourselves) we can be tempted into selling our winners in order to lock them in. The old saying, “No one ever went broke taking a profit,” is true. Profit-taking is essential. But not giving yourself the opportunity to have meaningful, long-term appreciation with your investments is to guarantee an oppressively low ceiling on your portfolio’s upside.

The win/lose mentality is similar to what is called “black and white” or “all-or-nothing” thinking. We see this not only with unsuccessful investors but also with unsuccessful dieters. Many chronic dieters approach their eating with no gray area, no room for moderation. They are either “on a diet” (very strict) or they are “off it” (no rules). When they veer off a plan, rather than stopping at one (okay, two) cookies with the reasoning that little harm has been done, they instead revert to the thought, “I’ve already gone off my diet. I may as well get my money’s worth here,” and proceed to finish the box of cookies (and possibly a pint or two of ice cream), consoling/justifying themselves with the refrain, “My diet starts on Monday. Again.”

We need to see gray areas and moderation in our investing, too. It saves us from extreme decisions and destructive frameworks. Investing for the future is not a game to be won or lost; it’s a process of accumulating enough wealth so that we can live and feel a certain way.

The financial media and casual conversations with friends will often draw us into thinking in terms of the win/lose mentality. Adopting and maintaining a life-focused, process-oriented frame is the key to beating this mental trap.

Avoiding Trap #1

• When you want to evaluate how your investments are doing, adopt a framework based on progress toward your life goals—they’re the reason you’ re investing in the first place. Are you in line to achieve your retirement plans? Is the college fund on track? These are much better evaluations than whether you’ re beating the S&P 500 this year—much less competitive, too.
• Do not allow your actions to be dictated by arbitrary timelines like a calendar or fiscal year. Tax implications aside, they are meaningless guideposts within the context of your long-term plan. The time to start investing is now, not January 1. Because you’re “having a bad year” is no reason to take on big risks to make up for it.
• Fight the temptation to “break even” on individual positions. You have a choice to make with your portfolio. You can either try to win every battle, or try to win the war. You cannot do both.

Trap #2: Down with the Ship Syndrome

As the last section indicated, we love to win. But we hate to lose even more! In fact, seminal research in the field of behavioral finance indicates that the pain of losing is felt 2 to 2.5 times more strongly than the joy of winning. 1

“Down with the ship” syndrome is rooted in this loss aversion. Intellectually, we know that not all of our investing choices in the stock market are going to work out. Some positions will lose money. But selling a position that is down means realizing the loss and experiencing pain, and not only the financial pinch, but the dull emotional ache that...

Table of contents

• Cover
• Title Page
• Copyright
• Chapter 6: Your Investor Blind Spots: Identifying (and Avoiding) Mental Traps