Investors are often their own worst enemy. And letting emotions and shortsightedness rule the decision making process has led to the undoing of many portfolios.
The field of behavioral economics uses psychology-based theories in studying the investment markets. And the field has four interwoven parts, according to Princeton psychology professor Daniel Kahneman. They could be called four pitfalls of investing.
The Prospect Theory:
According to this theory, investors sometimes behave irrationally. When confronted with a risky decision, investors will condense their options into a short list and choose the one that they perceive to have the highest value.
Loss Aversion:
Investors are more concerned about decreases in the value of their portfolio than they are about gains. Simply put, the fear of loss is greater than the motivation to achieve gains.
Mental Accounting:
Often times, investors will separate their finances into ‘mental boxes’ and use those boxes for different purposes. While that sounds harmless, it results in investors making short-term decisions about some ‘boxes’ that end up hurting their portfolio as a whole.
Overconfidence:
All too often, investors don’t want to admit a lack of background knowledge when managing their own portfolio. Displaying overconfidence when it comes to self-management of your portfolio is risky.
I would add another pitfall to these four…one that I think is the source of most investors problems: too much emotion and too little discipline.
Whether we want to admit it or not, we are hard-wired to let emotions prevent good investment decisions. Harvard economics professor David Laibson used MRI brain images in a recent study to prove that people are more emotional when they make money-related decisions for themselves.
The problem is that ‘investors don’t only want to win over time…they want to win all the time’. And that drive to win, and the psychological drive to avoid losses, is not the way to manage a portfolio. All this will do is lead to short-term, and shortsighted, decisions that hurt results in the long-run.
Most successful investors have one trait in common: the ability to strictly follow a set of rules…a written, rules-based strategy that is followed to the letter. Successful investors stick their strategy, and suspend the emotional desire to break from the rules when it seems to intuitively make sense. And I think Warren Buffet sums up this ability in one of his rules of investing: the most important quality for an investor is temperament, not intellect.