When It Comes To Investing We’re Our Own Worst Enemy
Fee-for-service financial planner and founder of PlanEasy.ca
Compounding interest is a beautiful thing. It’s like magic. Give it enough time and compounding interest can turn even the smallest amount of money into millions.
Investing CAN be as easy as that, just set it and forget it. But when it comes to investing, we’re our own worst enemy.
Without guidance, rules, plans, checks and balances, we as individuals can cause some serious damage to our investment portfolios. We’re biased in many different ways and those biases create many behavioral investing pitfalls to watch out for.
There are many different behavioral investing pitfalls to be aware of, but some are more common than others (especially now that investing is even more easy and accessible). Some can be reduced with new investment options that automatically rebalance but there is still a risk.
Are you currently making one of these three behavioral investing mistakes?!?
Why Should You Care? There Are 92,435 Reasons!
Why worry about investment behavior? Does it really matter?
Yes, it matters a lot.
A few small missteps, when compounded over time, can lead to some very large losses.
Behavioral investment mistakes can easily reduce investment return by 0.5% to 1% or more. Over time, that can have a significant impact!
Let’s consider a simple example with someone maximizing their TFSA each year and nothing else. We’ll assume a buy and hold investor gets a 5.0% return on average. In a second scenario we’ll assume they make a few behavioral investment mistakes over time that reduce their average return to 4.5%. Not a large difference, but over 40 years from age 25 to age 65 the impact is enormous.
Over 40-years the scenario with a simple buy and hold strategy has accumulated $763,010 in tax free assets.
Over 40-years the scenario with a few small behavioral investment mistakes has accumulated just $670,575 in tax free assets, a difference of $92,435!
A few small investment mistakes, over a long period of time, can have a very large impact on personal finances and personal wealth.
Mistake #1: Timing The Market
Market timing is so easy to do in theory, but impossible to do in practice. When looking at a historical investment chart it FEELS like it should be easy to identify future peaks and valleys.
As Warren Buffet says, “be fearful when others are greedy and greedy when others are fearful”. Simple advice, right? So, putting it into practice should also be simple… Buy low, sell high… Nothing too it. Should be easy.
In practice, identifying a market peak is impossible. Identifying a market valley is equally impossible.
Morningstar has done an analysis on investors buying and selling certain investments. They look at fund inflows and outflows to get a sense of when people are trying to time the market. The result? We’re terrible at it. Versus a simple buy and hold strategy the market timers on average underperformed the fund return by 0.33% to 2.61% (Details here.)
That’s a lot of money over time!
When it comes to investing what’s important is time IN the market, not timing the market. Invest early, invest often, buy highly diversified low-cost investments and hold forever.
Mistake #2: Misjudging Risk And Probability
Our brains are amazing, but they’re terrible at certain tasks. One of those tasks is assessing risk and probability. We think very intuitively but often probability and risk are not intuitive at all. This can lead to some large investment mistakes.
A good example of how terrible we are at assessing probability is the Money Hall problem…
Suppose you’re on a game show, and you’re given the choice of three doors: Behind one door is a car, behind the others, goats. You pick a door, say No. 1, and the host, who knows what’s behind the doors, opens another door, say No 3., which has a goat. They then say to you, “Do you want to pick door No. 2?” Is it to your advantage to switch your choice?
Many people assume that with 2-doors left the odds of choosing the right door is now 50/50, so switching doors from door No. 1 to door No. 2 doesn’t make a difference.
The reality is that by staying with door No. 1 the original odds remain the same, it’s 1 out of 3 that the car is behind door number 1, BUT by switching to door No. 2 the odds are now 2 out of 3 that the care is behind door number 2. Switching doors doubles the chance of getting a car!
This isn’t intuitive for many people and if this was an investment decision many people would end up with lower returns by sticking with door No. 1. (Interested in why the probability changes? Read more here.)
This is a great example of how we’re bad at misjudging risk and probability. We underestimate some risks and overestimate other risks.
This can lead to investors either taking on too much risk or taking on too little risk, and when it comes to investing, risk is tied to reward, so misjudging risk can have a large impact on returns.
Taking on the wrong amount of risk can also lead to some bad behavioral investment decisions. It’s important to match a portfolio’s risk level with personal risk tolerance. A mismatch can lead to investors feeling stressed, or worse, with them moving entirely into cash. Holding large amounts of cash is one of the worst things a long-term investor can do for their portfolio.
When it comes to investing, we want asses personal risk tolerance, we want to understand how investment risk works (hint: not all investment risk is the same), and we want to take the right amount of risk to achieve financial goals but not any extra.
Mistake #3: Swinging For A Home Run (And Not Diversifying)
Another very common investment mistake is “swinging for a home run”. This is even more common now with easily accessible online trading platforms.
This is similar to the “all your eggs in one basket” problem, but on steroids.
One common way to “swing for a home run” is through options trading. This has gotten a lot of attention recently with online trading platforms like Robinhood in the US making investing easy and more accessible, especially investing in options using margin.
Options are simple in theory, it’s possible to buy an “option” to either buy or sell an investment in the future at a certain price. For example, it’s possible to buy the “option” to buy shares of Apple at a certain price at a certain time in the future. The appeal of options as an investment is that they’re cheap relative to share price and are highly sensitive. If Apple is trading at $100 per share, some options could cost as little as $1/share, $0.10/share or even $0.01/share.
For example, if Apple is currently $100/share, it might cost $0.01/share for the “option” to buy Apple shares at $150/share in 30-days. This is because the likelihood of shares increasing by 50%+ over 30-days is quite low. If Apple shares do happen to go from $100/share to $160/share over that time, the option that originally cost $0.01/share is now worth $10/share (use option to buy at $150 and sell on open market at $160). The return is 1,000x. A $100 investment would be worth $100,000! You can understand the appeal.
When share prices change dramatically, options can increase in value by 10x, 100x or 1000x or more. It’s possible to turn $1,000 into $100,000+. But with options trading that $1,000 will more likely turn to $0 if the option expires “out of the money”.
Options trading is an extreme example, and it seems ludicrous to invest your retirement savings in stock options that could be worth $0 in a few days/weeks/months, but what is more common is “putting all your eggs in one basket”.
Having an investment portfolio highly concentrated in 1-2 investments is less risky than options trading, but it’s on the same spectrum, and it’s more common than you might think. It can often happen slowly over time. As certain investments grow, if they aren’t periodically rebalanced, they can quickly dominate a portfolio.
This lack of diversification greatly increases risk and when/if that investment decreases in value it can severely affect long-term returns (anyone remember Nortel?).
It can be very attractive to “swing for a home run”, which is why it’s a big behavioral investment pitfall, but when it comes it investing the goal should be high diversification, low-cost and steady returns over a long period of time.
Financial planner, personal finance geek and founder of PlanEasy.