5 Common Mistakes In Investment Decision Making

Written by Kate McCallum, Multiforte

With the current volatility in market, are you anxious about losing value in the short term? Do you want to trade your investments to ensure you're doing something? 

If you answered yes to these questions, then you're like most investors. 

While investing theory assumes that people are rational, most investors are not. Our decision making is influenced by biases, emotions and irrational behaviour that we may not be aware of; and even if we are aware of them, we may not be able to easily control them. 

"One key reason why individual investors systematically underperform professional investors is not that they're inherently worse investors", according to recent academic research, "but simply that professional investors are aided by a strong set of institutional rules that ensure greater control of their knee-jerk reactions."   

So, given the heightened market uncertainty, we have outlined here 5 common mistakes in investment decision making, and offered some "rules" that may help you to avoid them.   

Failing to see the big picture: we tend to focus on investment decisions one by one, without considering the impact on our overall portfolio. This means we could miss out on diversification opportunities, or avoid opportunities that look risky on their own but would be a good addition to our overall portfolio. 

Using a short term decision horizon: we base our decisions on anticipated performance over short time periods, even when our true time horizon is 5, 10 or even 20 years. The time horizon we pick makes a big difference to how we evaluate an investment. For example major equity indices post losses in about 40% of one month periods - which doesn't seem a good investment. However, over a one-year period the probability of a loss drops to 25%, then down to 19% over five-year period, down to 7% of the time over a 10-year period, and almost never over 20-year time frames. Perceived risk is magnified by short time horizons, and as a result, we may take less risk than we have capacity for. 

Buying high, selling low: we tend to more prepared to take risks when we're comfortable, and fewer when we're not. When are we comfortable? When markets have been rising for a while and we've been surrounded by good news. We're uncomfortable when we've been through times of stress and chaos. Unfortunately this means we all have a strong tendency to take on more risk when markets are high, and less when they're low: we buy high, and sell low ... and would do better just to buy and hold.    

Getting emotionally attached to concentrated investments: many investors hold a few highly concentrated investments that we have an emotional attachment to - perhaps a property, company shares, or an inherited asset. These are typically highly concentrated, add more risk than value to our portfolio. It is critical to review them objectively, and potentially sell down ... and reinvest in an efficient diversified portfolio. 

Action Bias: in volatile markets in particular, we have a strong bias towards wanting to do something - it makes us feel better. It may make sense to adjust your portfolio, or it may not. The more you trade, the higher your costs, and the higher the chance of trading emotionally or based on pure noise or inaccurate information. Most of the time the best advice is simply to do less than you're inclined to.    

What can you do to avoid these mistakes?

Self-control strategies include the use of checks, barriers and rules that aim to moderate and guide behaviour. There are a range of strategies, according to behavioural finance academics, to help us control our financial decision making .   

Here are just some of them that may work for you:

 

Avoidance- avoiding information about how the market or your portfolio is performing in the short term·

Rules- using rules to help you make better financial decisions (eg. Only switching investments after you have sought advice)·

Cooling off -waiting a few days after making a major financial decision before executing it·

Delegation- appointing a professional to manage your investment portfolio·

Planning- appointing an objective financial adviser can help ensure you spend time on your financial strategies and offers the accountability to help you stick with them.

Ultimately, your investment decisions are very individual - our approach is about helping you to preserve and grow your capital, while ensuring you can sleep at night. 

These volatile markets are exceptionally challenging - so if you would like to take a more structured and proactive approach in managing your money, please contact Multiforte by clicking here.