3 Investment Behaviors to Overcome
Your Portfolio's Worst Enemy May Be You
An even bigger challenge than creating an intelligent long-term investment strategy is sticking to that long-term plan--regardless of market turmoil, the media's constant investment advice and the recommendations of friends and colleagues.
You'll be a more successful investor if you learn to recognize--and resist acting on--emotions that can lead to costly mistakes. Among the most common:
LOSS AVERSION. Most investors would rather sell a winning investment than one that's under water. That's understandable, because selling the latter means accepting a loss. By contrast, when you sell a winner, you realize a profit. But in the long run, when you hold on to losing investments too long, you pass up the chance to invest in more promising alternatives. And if you free up cash for new investments by selling winners instead of losers, you may wind up selling your good performers too soon.
TIP: When you consider whether or not to keep a losing investment, base your decision on its fundamental value rather than what you paid for it. Ask yourself: Would I buy this investment today at its current price? If the answer is no, perhaps it's time to sell. To give your winners a chance to keep growing, adopt a disciplined rebalancing schedule to maintain your desired portfolio allocation. For example, consider rebalancing only when your asset mix has diverged more than 5 percentage points from your original target.
OVERCONFIDENCE. Surveys have repeatedly shown that most of us believe we have above-average skills at virtually everything. As an investor, too much confidence can hurt you. Consider, for example, the results of a five-year study of investors: The most confident investors traded more frequently but earned less--even without taking their higher trading costs into account--because their new purchases actually underperformed the stocks they sold. Over the length of the study, frequent traders netted an annualized 11.4% return, while the average household netted 16.4%.1
TIP: Avoid the temptation to micromanage your portfolio. Instead, focus on creating a disciplined way to implement your long-term strategy: Review your holdings yearly to make sure they still fit your needs. Look for ways to increase the amount you're investing. Make contributing easy and routine by setting up automatic deposits to your investment accounts.
READING TOO MUCH INTO RECENT MARKET TRENDS. Assuming that current market conditions will continue indefinitely can result in disastrous investment choices--like detouring from your long-term strategy to pour all of your money into dot.com companies during the 1999-2000 technology bubble, or selling out of stocks at the bottom of the 2008-09 bear market. Today's hot investment category won't sizzle forever, and last year's laggards may rebound to become next year's winners. Lacking a crystal ball, your best long-term plan may be to stay diversified.
TIP: Outline your long-term strategy in a written investment policy statement (IPS) and maintain your perspective by re-reading it before making any major investment decisions. Your IPS should include target allocations for each asset class you'll own, and for the subcategories you'll invest in to make sure you stay well diversified within each asset class.
Disciplining yourself to sidestep such emotional traps can help you avoid making impulsive investment decisions you'll later regret--and that's good for both your portfolio and your peace of mind.