There are many reasons why people don’t succeed at investing. Poor planning, impatience, a lack of skill, neglect, or overtrading, to name a few.
The discipline of Behavioral Finance has identified over 100 factors that can adversely affect investment outcomes. Below are ten key considerations that are especially relevant.
- Lazy greed, or a desire to get rich without putting in the time and effort required.
- Failure to recognize or admit to past mistakes.
- Preference for avoiding losses rather than making money.
- Fear of making the wrong decision.
- Overconfidence, or believing we know more than we do.
- Herd mentality — the tendency to follow the crowd because they must know something.
- Unwillingness to let winners run, preferring to take profits now.
- Overreliance on the most recent information.
- Assumption that previous success was due to our skill rather than simply a rising market.
- Looking only for information that validates our opinions and decisions.
How can investors avoid pitfalls they may not recognize?
One time tested and proven way is to put a framework in place for making investment decisions. When we clearly define what we’ll do and when we’ll do it, indecision goes away. Instead of reacting emotionally to a big drop in price, for example, we can instead consult our written framework and find out what our rational brain had to say when we wrote it. Here are six steps to build such a framework:
- List your investing goals, along with dollar amounts and when you will accomplish them.
- Create a written plan that spells out exactly how you will manage your investments. This plan is called an Investment Policy Statement, or IPS.
- Choose a strategy that fits well with your stated goals. You may have different strategies for different goals.
- Create portfolios that faithfully implement your strategies.
- Track your progress towards your goals and adjust your IPS if necessary.
- Set up a rebalancing schedule based on time or asset allocation percentages.
A written plan is effective because it engages our rational “System 2” thinking, rather than the emotional and impulsive “System 1,” as described by Daniel Kahneman in his book “Thinking, Fast and Slow”. By setting decision rules using System 2, we can take emotion out of the equation.
Here’s an example of a decision rule taken from an IPS I worked on with a client:
Ticker XYZ
Current price $35
Upside target $48
Downside limit $31
“If the price of XYZ stock rises to my target price, I will sell half of the position. For the other half, I will use a trailing stop order to prevent giving back all my gains. If the stock trades at my downside limit before it reaches my upside target, I will sell the whole position at the market.”
This client was very thorough when writing his IPS. He covered all the bases, from goal setting to decision rules to asset allocation percentages to annual rebalancing scheduling and everything in between. Now he is free to do other things and rely on the text alerts he set up to notify him that something requires his attention. His investments are essentially on autopilot. Yours could be too.