The Seven Deadly Sins of Investing; Financial crisis be damned—investors are still making the same mistakes the always have

August 30, 2013, 5:58 p.m. ET

The Seven Deadly Sins of Investing

Financial crisis be damned—investors are still making the same mistakes the always have.

KIRSTEN GRIND

It has been nearly five years since the depths of the U.S. financial crisis, and investors have learned a lot since then. Or have they? Despite the downturn that left many investors reeling from losses on everything from real estate to the stock market, when it comes to investor behavior—those hard-wired instincts that drive us all—little has changed, say psychologists and financial advisers. Investors still make the kinds of mistakes that have gotten them in trouble for decades. They are wooed by the hottest new trend, they want to follow the crowd—consequences be damned—and they just can’t seem to pay enough attention to important details, such as the steep annual fees charged by many mutual funds.“When it comes to money, we are operating as if we were in the jungle, having to deal with predators like tigers,” says Brad Klontz, a clinical psychologist and associate professor of financial planning at Kansas State University. “We have a caveman brain.”

There are ways to avoid these pitfalls. Investors need a hard and fast plan of their investment goals, they need to find a trusted adviser or family member to help weed through decisions and they need to stop paying so much attention to the short-term events that drive media coverage.

Here are the seven deadly sins of investing, in no particular order, and how to protect against them.

Lust: Chasing Recent Performance

The belief investors feel that recent performance will dictate future performance—known as “recency bias” in psychology—is one of the biggest investor pitfalls, experts say.

“People tend to buy something that has done really well recently,” says Terrance Odean, a professor of finance at the Haas School of Business at the University of California, Berkeley. “They chase performance.”

In the lead-up to the financial crisis, investors dived headlong into real-estate investments, convinced that rising housing prices would never falter.

The latest example: gold. The commodity went on a winning streak even before the financial crisis, and investors piled in.

A big factor was the heavy prominence gold suddenly received across the media—on commercials, in financial publications, on television shows and in books. Mark Berg, president of Timothy Financial Counsel, a fee-only financial advisory firm in Wheaton, Ill., says one otherwise rational client wanted to move her entire portfolio into gold after reading a book warning of another market crash.

To combat this behavior, financial advisers say it is important that investors study historical prices and performance of the latest popular investments. Historical charts, for example, will show the rise and fall of any investment over time.

Instead of looking just at prices over the past few months or a couple of years, look at the long-term history over periods extending back at least 10 years—and sometimes more. Gold, for example, had been increasing in price since 2001, but over the longer term has trailed stocks and barely kept pace with inflation.

Despite the multiyear frenzy, gold prices peaked in 2011 and are now trading about 26% below their record high.

Similarly, investor returns often lag those of the mutual funds they invest in, since many people buy funds only after their performance begins to overheat, then sell after the funds drop. As a result, the typical fund investor misses out on early gains and locks in the later losses—ending up falling behind the fund itself.

The average annual return for U.S. stock mutual funds over the past 15 years was 6.6%—while the average investor in those funds earned just 4.6%, according to investment research firm Morningstar.

While it is easier said than done, investors have to try not to pay attention to daily news reports and advertisements touting the latest popular investment.

Pride: Being Overconfident

Eric Glohr, 54 years old, new to investing at the time, planned to buy MicrosoftMSFT -0.45% stock at its 1986 initial public offering at $21 a share—less than a dime in split-adjusted terms, according to FactSet. But on the first day of trading, the share price shot up to more than $27, still less than a dime in split-adjusted terms.

Mr. Glohr decided to wait until it sank lower again. He waited for years as the stock marched higher until he finally realized it would never dip to the lower price he had anticipated.

Its peak price, in split-adjusted terms, was $59.56 a share on Dec. 27, 1999, according to FactSet.

“I was worried about a couple hundred dollars and I missed out on close to a million dollars,” he says.

Investors, especially ones new to the game, frequently believe they know far more than they actually do about a particular investment, say psychologists and financial advisers.

“Our opinion of ourselves is much too high,” says Mr. Odean, the finance professor. “We all need a healthy dose of self-doubt and humility.”

The best way for investors to keep their overconfidence in check is to make sure they have an unbiased third party available to go over all investing ideas. That could be a financial adviser, or it could be a trusted close friend or relative who isn’t directly affected by any decision.

Mr. Glohr, for his part, says he learned from his early mistake. Rather than trust his instincts entirely, he joined an investment club and now diligently researches each company in which he chooses to invest, bouncing ideas off the members of his group.

Sloth: Overlooking Costs

Investors often just don’t pay attention to details. Consider their willingness to invest in expensive mutual funds that don’t perform well, says James Choi, an associate professor of finance at Yale School of Management.

Investors, wooed by a fund manager’s name or recent performance, fail to look at a fund’s expense ratio before buying in. Rather than buy a cheap index fund that mimics a broad market index, such as the S&P 500, with an expense ratio of as little as 0.05%, investors will buy one managed by a professional stock picker that charges a much higher fee, Mr. Choi says.

But more expensive funds tend to underperform less expensive ones, says Mr. Choi, citing numerous studies.

It is the same with 401(k) fees. Investors often won’t pay attention to their statements even though taking an active role in choosing their investments would likely save them thousands of dollars in the long run, say experts.

While a 401(k) investor doesn’t hold much sway over the administration fees charged by the provider—or even the choice of provider—there are ways to manage costs, say financial advisers. Often 401(k) plans will give investors a choice of funds in certain asset classes, with expense ratios that vary. Mr. Choi recommends choosing the cheapest option.

“The expenses are much more predictive of future performance because there’s so much randomness in past performance,” he says.

Envy: Wanting to Join the Club

What is better than a great deal? A great deal available only to you.

In the run-up to Facebook‘s FB +0.03% initial public offering in May 2012, financial advisers say they were slammed with calls from clients who wanted to get in on the stock before it made its debut. The fact that there were a limited number of shares available to retail investors only drove the frenzy, advisers say.

It is the same reason investors were so willing to believe in Bernard Madoff’s Ponzi scheme, experts say. They were part of a small group making a lot of money; Mr. Madoff reportedly only accepted a limited number of clients.

“A lot of that has to do with that sense of exclusivity,” says Meir Statman, a professor of finance at Santa Clara University who focuses on behavioral finance.

The desire to be part of an exclusive offering often drives people to throw money into an investment that doesn’t fit into the overall goals of their portfolio, against their better judgment. Investors who poured money into Facebook just after its launch watched as the company’s stock fell below $20 a share several months later, far less than its $38 IPO price. (The stock is now trading at about $41.)

Susan Strasbaugh, owner of Strasbaugh Financial Advisory in Colorado Springs, Colo., which has $100 million in assets under management, says she recommends clients set up a separate “Vegas” account for hot investments like Facebook that don’t fit into a client’s portfolio.

She says clients should invest no more than 5% of their portfolio in the Vegas account, and treat it like gambling—hence the name.

Wrath: Failing to Admit Failure

People hate to lose money. Along with her investing club, Lori Towers-Hoover, 54, bought shares of home builder Meritage Homes at about $32 a share in 2007. Ms. Towers-Hoover and her club in Howell, Mich., had thoroughly researched the company and believed in its strong financials. But the stock already was on its way down, and by early 2009, it was trading at less than $10 a share.

Ms. Towers-Hoover and her club hung on. They waited for another year as the stock hovered around $20. Finally they sold. “We just made the decision it’s not going to rebound and we’re not going to get our money back,” she says.

Loss aversion, as it is called by psychologists, isn’t hard to spot. Investors held on to tech stocks as they plummeted during the crash of the early 2000s, as they did to financial stocks during the crisis, and as they continue to want to do today.

“We don’t want to be honest with ourselves and admit the loss,” says Mr. Klontz, the psychologist.

That type of thinking can be dangerous for investors. If they regret a decision, they may sell too soon, but if they can’t accept their loss and move beyond the “sunk costs” of an investment, they may hold on too long, say psychologists.

Instead of just researching the financials of a particular stock, investors need to understand the economic environment as much as possible, say financial advisers and experts. If a company is dependent on a job-market or housing-market recovery to perform well, investors need to fully understand the outlook for those sectors and plan their investment accordingly. Too often investors will base their decision to buy or sell solely on the strength of a company.

Of course, economic predictions aren’t always correct. Ms. Towers-Hoover says her club’s decision to sell Meritage was based on predictions that the U.S. wouldn’t fully recover from the 2008 downturn until 2016. But, buoyed by a housing-market recovery, Meritage stock began to rise in mid-2011 and is trading around $40 a share now.

That stock’s recent tear taught Ms. Towers-Hoover another lesson: It is impossible to time the market.

Gluttony: Living for Today

Let’s face it: There are a host of activities more interesting than monitoring your 401(k)—and a host of temptations to spend money on today. But investors’ tendency toward apathy is damaging, particularly when it comes to retirement savings.

Fifty-seven percent of U.S. workers surveyed by the Employee Benefit Research Institute earlier this year reported less than $25,000 in total household savings and investments, not counting their house or defined-benefit retirement plans. The lack of preparedness has led experts to deem it a crisis.

Often workers aren’t saving early enough because they view retirement as a far-off event, leading to apathy toward putting money away, say financial advisers and psychologists.

The key for investors, Mr. Klontz says, is making retirement less abstract. Investors should ask themselves a series of questions about how they want their lifestyle to be when they retire: How old will they be? Where will they live? What will they be doing?

Mr. Klontz also uses a measuring tape to make this point, marking it at an investor’s age and then again at the age an investor expects to live until, based on the longevity of other family members. When an investor is looking at a length of tape that is only, say, 20 or 30 years long, that can be a stark realization of the lack of time he has left to save.

Often, Mr. Klontz says, this encourages investors to add more to their 401(k) contributions or ratchet back spending.

Greed: Following the Herd

When the stock market tanked during the 2008 financial crisis, many investors fled, some abandoning their entire portfolios and putting the money into cash. The same phenomenon is happening now in the bond market as investors, worried about the effect of rising interest rates, are fleeing bond funds.

Investors yanked $11.7 billion from the funds in July, according to Morningstar, following an outflow of $60 billion in June. As investors pull money, it encourages more investors to do the same.

To battle the fear that inevitably comes with a market decline or other adverse events, financial advisers say it is crucial that investors have a detailed portfolio plan that they stick with regardless of short-term events. The plan should outline investors’ targeted holdings in bonds, stocks and other investments, and be based on their retirement goals.

“Right now, bonds are bad in the minds of investors,” says Chad Carlson, a wealth manager at Balasa Dinverno Foltz in Itasca, Ill., which has $2.6 billion in assets under management. “Our clients will say, ‘I want to be out of bonds entirely.'”

Rather than encouraging an “all or nothing” approach, Mr. Carlson recommends that investors adjust their portfolio a small amount. For example, a client who previously held 40% of his portfolio in bonds would reduce that exposure by several percentage points.

That move tends to reassure investors and helps them avoid rash decisions, he says.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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