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A list of Dan Richards’ previous articles appears at the end of this article.
Recently, a money manager told me his investing motto comes from the words of Polish composer Frederic Chopin:
“Simplicity is the final achievement. After one has played a vast quantity of notes and more notes, it is simplicity that emerges as the crowning achievement.”
It’s easy to make investing complicated. By contrast, Warren Buffett has said that all it takes to invest successfully is having a sound plan and sticking to it – and it’s the “sticking to it” part that investors struggle with the most.
To understand why investors fail to stick to their plans, economists and academics are studying the rapidly growing field of “behavioral finance,” analyzing the patterns of behavior that cost investors serious money. In fact, an entire branch of economics has sprung up around this issue. Israeli psychologist Daniel Kahneman was awarded the 2002 Nobel Prize in economics for his contributions to this movement,. (As an aside, one commentator said at the time that a psychologist winning the Nobel price in economics was akin to a history professor winning the prize in physics.)
Lisa Kramer, my colleague at the University of Toronto’s Rotman School of Management, has written extensively on this topic. She’s now doing research at Stanford University while on sabbatical, and she spoke with me about some costly behaviors that can trap your clients.
Overconfidence
When it comes to long-term investing success, perhaps the biggest problem stems from overconfidence in our investing knowledge and ability. This isn’t true just of investing – overestimating ability can be costly in many aspects of our lives.
Ask an audience if their driving ability is above or below average – typically 95% will say they’re in the top 50%. As a result, people believe that talking on a cell phone or texting while driving might be dangerous for others, but their outstanding driving skills mean they can get away with this.
Research by Terrance Odean and Brad Barber of the University of California shows a natural tendency to overestimate our investment knowledge as well – particularly among men. And just as overconfidence leads to car crashes, it causes investor portfolios to go on the rocks.
Many do-it-yourself investors believe that by nimbly jumping in and out of stocks, they can beat the market. Odean and Barber dug deep into the records of heavy traders at a discount brokerage firm. They discovered there’s an inverse correlation between the amount of trading and investor returns – the more trading you do, the lower your chances of success. And even if investors do show a paper profit, commission costs often turns that into a loss.
Their conclusion: “Excessive trading is dangerous to your wealth.”
Along the same lines, it’s not uncommon to see corporate executives with the bulk of their net worth in the shares of their company and other companies in their industry. They believe their unique vantage point and industry knowledge give them an advantage – to the point that their firm or the whole industry go off a cliff.
