John Mauldin on Why Investors Fail

One of my favourite newsletter is from John Mauldin's Frontlinethoughts.com

Today's newsletter features an article called Why Investors Fail where John featured a report from Gavin McQuill from Financial Research Center.

• Investors Behaving Badly
  
  Gavin McQuill of the Financial Research Center sent me his rather brilliant $5,000 report called "Investors Behaving Badly." He was the author and he did a great job. I read it over one weekend, and refer to it again from time to time.
  
  Earlier we looked at a report which showed that over the last decade investors chased the hot mutual funds. The higher the markets went, the less likely it was that they would buy and hold. Investors consistently bought high and sold low. Investors made significantly less than the average mutual fund did.
  
  McQuill focused on six emotions that cause investors to make these mistakes. You should read these and see whether some of them are familiar.
  
  1. "Fear of Regret - An inability to accept that you've made a wrong decision, which leads to holding onto losers too long or selling winners too soon." This is part of a whole cycle of denial, anxiety, and depression. As with any difficult situation, we first deny there is a problem, and then get anxious as the problem does not go away or gets worse. Then we go into depression because we didn't take action earlier, and hope that something will come along and rescue us from the situation.
  
  2. "Myopic loss aversion (a.k.a. as 'short-sightedness') - A fear of losing money and the subsequent inability to withstand short-term events and maintain a long-term perspective." Basically, this means we attach too much importance to day-to-day events, rather than looking at the big picture. Behavioral psychologists have determined that the fear of loss is the most important emotional factor in investor behavior.
  
  Like investors chasing the latest hot fund, a news story or a bad day in the market becomes enough for the investor to extrapolate the recent event as the new trend which will stretch far into the future. In reality, most events are unimportant, and have little effect on the overall economy.
  
  3. "Cognitive dissonance - The inability to change your opinion after new evidence contradicts your baseline assumption." Dissonance, whether musical or emotional, is uncomfortable. It is often easier to ignore the event or fact producing the dissonance rather than deal with it. We tell ourselves it is not meaningful, and go on our way. This is especially easy if our view is the accepted view. "Herd mentality" is a big force in the market.
  
  4. "Overconfidence - People's tendency to overestimate their abilities relative to individuals possessing greater expertise." Professionals beat amateurs 99% of the time. The other 1% is luck. The famous Clint Eastwood line, "Do you feel lucky, punk? Well, do you?" comes to mind.
  
  In sports, most of us know when we are outclassed. But as investors, we somehow think we can beat the pros, will always be in the top 10%, and any time we win it is because of our skills and good judgement. It is bad luck when we lose.
  
  Commodity brokers know that the best customers are those who strike it rich in their first few trades. They are now convinced they possess the gift or the Holy Grail of trading systems. These are the people who will spend all their money trying to duplicate their initial success, in an effort to validate their obvious abilities. They also generate large commissions for their brokers.
  
  5. "Anchoring - People's tendency to give too much credence to their most recent experience and to show reluctance to adjust their current beliefs." If you believe that NASDAQ stocks are the place to be, that becomes your anchor. No matter what new information comes your way, you are anchored in your belief. Your experience in 1999 shows you were right.
  
  As Lord Keynes said so eloquently when forced to acknowledge a shift in a previous position he had taken, "Sir, the fact have changed, and when the facts change, I change. What do you do, sir?"
  
  We expect the current trend to continue forever, and forget that all trends eventually regress to the mean. That is why investors still plunge into index funds, believing that stocks will go up over the long term. They think long term is two years. They do not understand that it will take years - maybe even a decade - for the process of reversion to the mean to complete its work.
  
  6. "Representativeness - The tendency of people to see patterns within random events." Eric Frye did a great tongue-in-cheek article in The Daily Reckoning, a daily investment letter (www.dailyreckoning.com). He documented that each time Sports Illustrated used a model for the cover of their swimsuit issue who came from a new country that had never been represented on the cover before, the stock market of that country had always risen over a four-year period. This year, it is time to buy Argentinian stocks. Frye evidently did not do a correlation study on the size of the swimsuit against the eventual rise in the market. However, I am sure some statistician with more time on his hands than I do will brave that analysis.
  
  Investors assume that items with a few similar traits are likely to be associated or identical, and start to see a pattern. McQuill gives us an example. Suzy is an English and environmental studies major. Most people, when asked if it is more likely that Suzy will become a librarian or work in the financial services industry, will choose librarian. They will be wrong. There are vastly more workers in the financial industry than there are librarians. Statistically, the probability is that she will work in the financial services industry, even though librarians are likely to be English majors.