Addressing Common Do-It-Yourself Investor Mistakes
Meet Lee the DIY Investor
Lee is a committed DIY investor who has been carefully building an investment portfolio over the years. His financial assets include a wide range of investments that he has assembled to meet his long-term goals. Like many DIY investors, though, Lee has faced a few metaphorical bumps and bruises along the way. This is a story about Lee’s investment journey, the biases that influenced his decisions, and the strategies he implemented to stay on track.
A Morning Revelation
One Saturday morning, Lee wakes up and prepares to meet his friends for their usual weekly breakfast. Before beginning his 15-minute stroll to the restaurant, Lee takes a quick look at his spreadsheet to see where he stands at the end of the week. He reflects on the state of his portfolio and the various decisions he’s made over the years to get where he is; he wonders if he’s fallen into any common DIY investor traps.
The Breakfast Gang
At the diner, Lee meets his three friends: John, Dave, and Bob. Each has his perspective on investing, and their discussions often reveal different insights.
Lack of Diversification
After the guys get their morning orders in, which amounts to their respective versions of “the usual,” Lee opens the conversation with, “I’ve been doing a deep dive into diversification – hey, how’s that for alliteration? – but now I wonder if I’m diversifying enough. I used to think that picking from among the largest Canadian dividend stocks was the best way to go, but a lot of what I’m reading is telling me that I’m too narrowly focused. What do you guys do?
John immediately replied in his usual self-assured manner. “You know me, Lee. I always think I’m right and that I know how to pick the best stocks. But, a while back I read an article about behavioural finance and discovered I was a classic example of someone with overconfidence bias.[1] What a surprise, eh? I was so impressed by that article I made a list of those behavioural biases we DIY investors tend to have, and I have it right here on my phone. Oh, and just to be clear, Lee, don’t limit yourself to Canadian stocks. The US market makes up about 60% of the value of the global stock market. You shouldn’t avoid it.”
***
Strategies to Mitigate Lack of Diversification
Select a globally diversified portfolio of assets, including both equities, adding fixed income and cash equivalents in keeping with your risk profile. This can often be addressed with a single Exchange-Traded Fund (ETF) like the model portfolios presented on the Canadian Portfolio Manager Blog.
***
Market Timing
“I like to think I have a pretty good handle on the economy,” Dave chimed in. “For that reason, I’ve not been shy about attempting market timing strategies. I even began working toward the Chartered Market Technician designation so I could improve my skills in technical analysis. I have to admit, though, it’s been a hit-and-miss approach.”
“I agree, Dave,” concurred Lee. “Market timing always seemed way too tricky for me to even attempt it. Whether my dividend stock strategy was the best or not, I just decided to put new money into the market every quarter and let the market take care of itself.”
John spoke up. “Dave, according to the behavioural scientists, your adventures in market timing reflect the illusion of control[2] and hindsight bias.[3] In other words, we think – and I include myself in this attitude – that we can control the market or predict what’s going to happen based on past events. It’s just not realistic.”
***
Strategies to Mitigate Market Timing
Adopt a long-term investment perspective and utilize automated investment services to avoid impulsive decisions. Consistent investing, regardless of market conditions, usually yields better results.
***
Emotional Investing
Finally, Bob spoke up, “There have been times over the years when I made decisions based on fear or greed, especially during market swings. Back in the late 1990s when the NASDAQ was booming with .com stocks, I thought I had to get into that. Maybe a little speculation is OK once in a while, but I put too much into my kids’ RESP – of all places – and regret that choice to this day. And when the Global Financial Crisis roiled the markets in 2008 and 2009, although I didn’t do much, I had a hard time sleeping. I was almost paralyzed with fear.”
“Wow, Bob,” exclaimed John. “I would have never thought that of you. You always seem so calm about everything. But even you are susceptible to the herd instinct[4] and loss aversion.[5] Yes, behavioural finance has defined those behaviours, too.”
***
Strategies to Mitigate Emotional Investing
Set clear rules. Establish a long-term strategic asset allocation based on well-founded research and stick to it. Stay informed but do not make impulsive decisions based on short-term fluctuations, whether down or up.
***
Ignoring Fees and Expenses
John went on, “One of the stupider things I used to do was to ignore fees. I thought that they were insignificant as long as I made a decent return. I now realize that they really add up over time.
“In fact, one of the articles I was reading referred to my behaviour as anchoring bias[6] and neglect of probability.[7] We anchor on the potential returns and ignore the probability of fees eroding those returns.”
***
Strategies to Mitigate Ignoring Fees and Expenses
Compare different investment options and their costs within the same asset category. Look at the probable long-term returns of the asset category you are thinking of investing. Remember that the “expense ratio is the most proven predictor of future fund returns.”
***
Failure to Rebalance
“This is like true confession time this morning, isn’t it,” said Bob. “OK, I have to confess that I’ve ignored rebalancing my portfolio a lot of the time. I figured I’d just let the winning asset category just keep going since it was doing fine so far.”
John took a quick look at his list and said, “Bob, it sounds like you were describing status quo bias[8] and being influenced by the endowment effect.[9] These behaviours reflect a sense of comfort with your current situation even when it’s no longer an appropriate allocation for your circumstances.”
***
Strategies to Mitigate Failure to Rebalance
Set a schedule on the calendar or a percentage trigger to review and rebalance your portfolio periodically. Use predefined criteria for rebalancing to avoid any emotional attachments. For example, you might schedule rebalancing annually. Alternatively, if a holding deviates by more than 5% percentage points from its target allocation, that will trigger rebalancing.
***
John had many more biases listed on his phone, but they decided to shift to something less focused on their respective shortcomings. Lee complained about the state of pop music, John lamented the Blue Jays’ mediocre standing in the American League, and Dave said he was enjoying a re-read of some classic science fiction that he hadn’t read since high school and which itself had been written before he was born. Bob talked about the genealogical study of his ancestors, insisting he was descended from Polish royalty. On that note, they all laughed at Bob, including Bob himself, who bowed with mock ostentation, and then they went their separate ways.
As Lee walked home, he reflected on their conversation. He realized more than he had until then that saving the cost of advice by forgoing an investment advisor might have helped him at one level, but it also left him open to the kinds of behavioural biases that could meaningfully hinder his long-term returns. He needed to re-think his investment process to limit the negative impact on his returns of the biases he carried with him.
If you have similar experiences or strategies to share, join the conversation on my social media accounts listed below.
[1] “Overconfidence bias is a cognitive bias in which individuals tend to overestimate their abilities, knowledge, and skill in a particular area, leading them to make errors in judgment and decision making.” https://www.investopedia.com/overconfidence-bias-7485796
[2] The illusion of control bias is a type of cognitive bias that leads people to overestimate their ability to control events that are actually uncertain. https://www.investopedia.com/illusion-of-control-bias-7377200
[3] Hindsight bias is a psychological phenomenon that allows people to convince themselves after an event that they accurately predicted it before it happened. This can lead people to conclude that they can accurately predict other events. Hindsight bias is studied in behavioural economics because it is a common failing of individual investors. https://www.investopedia.com/terms/h/hindsight-bias.asp#toc-what-is-hindsight-bias
[4] The term herd instinct refers to a phenomenon where people join groups and follow the actions of others under the assumption that other individuals have already done their research. Herd instincts are common in all aspects of society, even within the financial sector, where investors follow what they perceive other investors are doing, rather than relying on their own analysis. https://www.investopedia.com/terms/h/herdinstinct.asp#toc-how-to-avoid-herd-instinct
[5] Loss aversion in behavioural economics refers to a phenomenon where individuals perceive a real or potential loss as psychologically or emotionally more severe than an equivalent gain. https://www.investopedia.com/terms/l/loss-psychology.asp
[6] Anchoring is a heuristic (a mental shortcut that simplifies decision-making) that describes the subconscious use of irrelevant information, such as the purchase price of a security, as a fixed reference point (or anchor) for making subsequent decisions about that security. https://www.investopedia.com/terms/a/anchoring.asp#toc-anchoring-bias
[7] Neglect of probability bias is the tendency to completely disregard probability while deciding under uncertainty – a simple way in which investors and market participants can violate the normative rules of decision making. https://www.linkedin.com/pulse/cognitive-biases-investing-neglect-probability-varuna-technologies/
[8] Status Quo bias. Humans are creatures of habit. Resistance to change affects investors’ portfolios through a preference for maintaining the current investments. https://www.investopedia.com/terms/b/bias.asp
[9] The endowment effect refers to an emotional bias that causes individuals to value an owned object higher, often irrationally, than its market value. https://www.investopedia.com/terms/e/endowment-effect.asp
This is the 253rd blog post for Russ Writes, first published on 2024-07-08
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