A few weeks ago, I brought my car to the dealership for some routine maintenance and they gave me a brand new 2017 model as a loaner for the day. As part of the car’s “infotainment system”, you could enter stock tickers and get price quotes right there on the screen of the car.
Aside from the obvious danger of distracted driving, does the outcome of my retirement plan actually hinge on having this information available 24-7? Will I be wealthier if make trades from my phone while stuck in rush-hour traffic?
Unfortunately, increasing our access to information does not guarantee we can use that information profitably. In fact, I believe that the more we focus on short-term issues, the more we endanger the long-term outcomes. Be careful of missing the forest for the trees.
The field of behavioral finance has identified many seemingly innate, but irrational, behaviors which can be hazardous to our wealth. The more information we have, the more frequently we are compelled to “do something” in terms of our investment allocation. Unfortunately, the more investors trade, the worse they do, on average, because of these behavioral tendencies.
Here are four behavioral patterns which can become a problem for all investors:
The more information we have, the more strongly we believe that we can predict the outcome. Closely related is confirmation bias, which is where we place more weight on information which supports our existing point of view, and tend to ignore evidence which is contrary.
2) Disposition Effect
Many investors are willing to sell their winning trades but are very reluctant to sell their losing positions. “The loss isn’t real until you sell – it has to come back eventually!” What we should do is to ignore what we paid for a position and look objectively at how we expect it to perform going forward. If there are better opportunities elsewhere, we should not hold on to losers.
3) Home Bias
Investors prefer to invest in domestic companies, when left to their own devices. They miss the benefits of investing globally. See How a Benchmark Can Reduce Home Bias.
4) Naive Diversification
If a 401(k) plan offers five choices, many investors will simply put 20% into each of the five funds, regardless of category or their own risk tolerance. I’ve also seen portfolios that have multiple holdings in the same category, most often US Large Cap. When the market drops, having seven large cap funds will not offer any more defense than having one fund.
I mention these behavioral faults because you are inevitably going to see many articles over the next two weeks predicting what is likely to occur in the year ahead. Reading these is a waste of your time. The reality is that no one has a crystal ball and can predict the future.
Forecasters’ abilities to predict the stock market has been so poor and inconsistent, that if you actually look at a large number of past predictions, you will immediately recognize that their investment value is non-existent. There is often a great deal of group think and a Bullish bias from firms who get paid to manage investments. Others seem to be permanently Bearish, but still get press coverage in spite of being wrong for years at a time.
The good news is that you don’t have to know what 2017 has in store to accomplish your long-term goals. We need to think bigger than just one year at a time, so here’s a reminder of what we do:
- Create a financial plan to lay out the steps to achieve your long-term goals.
- Invest in a disciplined, diversified asset allocation based on your needs, risk tolerance, and risk capacity.
- Pay attention to risks, taxes, and our returns.
- Monitor, adjust, and rebalance to stay on course.
The more we allow short-term noise to dictate our long-term investment strategy, the greater risk we are to our own success. If your car offers stock quotes, may I suggest you instead set it to weather or sports? Your portfolio will thank you for it.