Finance

Learning from Mistakes

Recognizing patterns and analyzing portfolios

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It is easy to list bad habits that investors often make. It is harder to help people learn from their investing mistakes.

Dalbar, Inc., a financial services market research firm, is well known for its annual study, Quantitative Analysis of Investor Behavior, which compares gains on the S&P 500 stock index to returns received by the average equity mutual fund investors. For 1990-2010, the gap in annual returns was: 9.14% for the S&P vs. 3.27% for the average investor. The discrepancy is often attributed to harmful trading behaviors that retail investors make – such as buying high and selling low or trading too frequently. One interpretation of the study results is that retail investors are doomed to repeat the errors of their ways, unless they actively try to change their behavior.

As a lifelong investor and someone responsible for managing other people’s money, I know how important (and hard) it is to actually change investing behavior. We all have patterns of thinking that impact how we make decisions. Yet most investors are not fully conscious of how their biases and habits are influencing their choices of investment holdings and the timing of their trades.

Admit Mistakes

Making mistakes is part of investing. They can come in a variety of forms: timing of buying and selling, frequency of trades, over-concentrating in one position, allowing the law of inertia to take over, being in an investment at the wrong time. Mistakes aren’t losses per se, but rather a set of behaviors that, when taken together, lower your returns.

The first step is to recognize the patterns. Some statements I hear often are:

“I guess I hit the panic button at the wrong time.”

“I don’t want to make changes now; the portfolio is doing well.”

“I hate this stuff. I don’t even bother to open my statements.”

If this sounds familiar, admit that your investing decision-making needs improvement.

Measure What You Did Wrong

While the first step is confessing that you have made mistakes, measuring the impact of your decisions is equally important.

One helpful tool is to track how each of your holdings has done, not only while you own it, but after you have sold it. Recall what drove each decision to buy or sell and ask yourself, “Was my reasoning correct? Did the fund/stock behave the way I thought it would?” Sometimes underperformance is the result of things you can control (timing) and other times not (geopolitical events).

A second way of measuring mistakes is to compare your investing performance to one or more benchmarks. With a balanced portfolio, you might want to capture 55% of the upside and 45% of the downside of the equity markets. How close did you come? If not close enough, what could you have done differently?

A third way is to analyze each of your current holdings. Does the story behind their purchase still apply? Just because a holding was good once upon a time, doesn’t mean it still fits your investment plan.

Become Dispassionate

Emotions are an investor’s worst enemy. As is commonly recognized, fear causes investors to flee at the bottom of the market and greed leads investors to buy at the top. But there are other emotions that can play into your decisions.

Doubt – “What if I am wrong?” plagues some investors who become frozen with worry over what they do not know.

Attachment – even if a favorite falls from grace, it becomes hard to sell because the investor believes its glory days will come again.

Hindsight bias – the past haunts investors who project recent history onto the future. Many investors are currently holding cash on the sidelines, afraid to re-enter into equities in case 2008 happens all over again. During the 2000-2002 downturn, investors refused to sell equities because they feared they would miss out on the next leg up.

Put It All Together

An understanding of your past mistakes should be part of any disciplined approach to investing. When deciding whether to buy/sell a particular fund stock or bond, add a mental mistakes factor to your analysis of valuations, performance, risk and underlying statistics. If you have a tendency to hang onto holdings too long, force yourself to identify one holding you would sell – when and why.

If you are trigger happy, write down the reasons why you should not sell a particular holding. Then if it takes a dive, you are less likely to jettison the asset during a temporary pullback.

If you are frozen, do some homework. Read about investments, study what you have, and determine what steps you could take within your immediate comfort zone. Once you feel more confident, you should be able to make better, longer-term decisions.

Habits are hard to break. But in this day of global uncertainty and high volatility, it is hard enough to earn decent returns without adding to underperformance through the error of your own ways.

Betsey Purinton, CFP® is Managing Director and Chief Investment Officer at StrategicPoint Investment Advisors in Providence and East Greenwich. You can e-mail her at bpurinton@strategicpoint.com.