Many posit the theory of rational man, who coolly and carefully calculates his self-interest in a logical manner. We all fall somewhat short of that ideal. In the financial markets, irrationality can be costly. What are some of the common foibles, and what can we do to minimize their damage to our portfolios?
Don’t Make Decisions Based on What You Paid For an Investment
How often do you hear an investor say that I can’t sell until I get back to even? Or that you should sell when you are down a certain percentage from your cost?
It can work the other way: “When you’ve made a certain amount sell a number of shares to recoup your cost so you’re just playing with the House’s money.” “Don’t get greedy, sell when you’ve made 20 percent.”
The problem with any of these approaches is what you previously paid has no bearing on the merits of today’s transaction. Try to analyze any particular trade as if you didn’t own the security.
Everybody loves buying into a swiftly rising investment. It’s human nature to want to extrapolate the recent past into the future. A fund is doing well, a stock is performing, so we have the urge to jump on board to participate in the seemingly obvious continued gains.
The problem is if a stock or fund is doing well, it means not too long ago it was cheaper, so you are setting yourself up to buy high. That’s not a recipe for success.
Multiple studies have shown that most investors fail to capture the returns of most mutual funds. They pile in “after the train has left the station,” then when the performance inevitably cools, they bail, thus buying high, selling low.
Avoid buying an investment based on extrapolating a trend. All trends come to an end, and if you’ve paid too much it could be very painful.
Avoid the Herd
If everyone else is into an investment, avoid it. Excessive interest creates unsustainable valuations. The investment herd moves in and out, and when it moves out you could be stuck with a losing investment.
How to tell if an investment is too popular? Outsized recent gains are one indicator. The media reporting that there’s been large inflows into particular funds or ETFs is another. Positive cocktail chatter is one more. Bragging over recent big profits is a kiss of death for the investment.
Consider instead the unloved. Before you protest that nobody’s buying that investment, consider that for every investor dumping the stock, somebody else must be buying it. Consider whether you are spying a potential bargain.
In light of these human foibles, what steps can you take to help reduce portfolio risk?
Develop an investment plan. It should be in writing and should reflect allocations across a diversified set of investments. The allocations should be in percentages and include investments that will not move in lockstep with the others.
Periodically, when market developments cause your portfolio to deviate from the plan, re-balance back to the percentages. The plan will help you fight your tendency to follow trends and embrace rosy outlooks and stories.
The plan should be long term. Eschew changes based on short term considerations. Although the plan may be adjusted for developments in your personal circumstances, it should remain impervious to changes in market outlook.
Contrarian Investments Today
Europe is out of favor. Following Brexit, the Continent may struggle over the loss of a key trading partner. Europe causes skepticism because its members are locked together via a common currency, but without coordinated fiscal policies.
Long dated Treasury bonds are considered toxic. Most investors see interest rates rising soon and materially. This would be anathema to these bonds because their interest payments are set for such a long period of time.
Fossil fuel investments are unpopular. Technological advances have made supplies quite abundant, creating a glut. Many are hostile to fossil fuels, seeing them as polluting our environment and creating global warming.
Emerging markets, in particular Latin America, are widely shunned. They are castigated for being too reliant on volatile commodities. Much of their borrowings are in US Dollars. Dollars are believed to soon appreciate, making repayment difficult. Political risk is deemed large.
Japan is at or near the top of the list of the unfavorites. Its Nikkei stock index peaked in 1989 and is now down more than half. Government debt is nearly double ours as a percentage of GDP, and its population is aging rapidly.
Investments in any of these could be the surprise winner over the next decade.
Note: David G. Dietze, JD, CFA, CFP™ is President and Chief Investment Strategist of Point View Wealth Management, Inc., a registered investment advisor at 382 Springfield Avenue, Summit.
CNBC has named Point View to its list of the top 100 fee-only wealth managers in America! See http://www.cnbc.com/2015/06/03/cnbc-charts-the-top-100-firms.html
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