One of the country’s leading experts in behavioral finance is a Santa Clara University professor by the name of Dr. Meir Statman. Some readers may recognize Dr. Statman’s name right off the bat. He has published numerous articles and books about investor psychology, and he has done extensive research on investment decision-making – detailing common errors, biases, blind spots, and so on. His recent article titled “The Mental Mistakes that Active Investors Make” caught my attention.1
I’ll start with Dr. Statman’s overarching conclusion: investors are their own worst enemies. Investors make decisions at just the wrong times. Emotional responses get in the way of sound judgment. Fundamental analysis and a disciplined investment approach are tossed out the window at the first sign of scary volatility. Overconfidence gives way to shunning or ignoring risk. The list goes on.
Why do investors continue making the same mistakes? But also, why do everyday investors continue trying to invest on their own, in an effort to beat the market?
Here are four mental mistakes that I think are among the biggest threats to achieving attractive long-term returns.
- Practice Doesn’t Make Perfect
With many skills in life, the more you practice, the better you get. If you’ve played the piano 1,000 times, you’ll almost certainly be better than a person who has played piano ten or even 100 times.
Trading in the stock market is not like playing the piano. The piano is an instrument that doesn’t change as you learn it, and it is not competing against you. The equity market, on the other hand, is constantly responding to different factors, economic data, earnings reports, interest rates, and so on. There is also fierce competition in the market – there is always someone on the other side of the trade, trying to be the winner.
Trading too often makes an investor vulnerable to making decisions on incomplete information, gut instincts, or emotional responses. For these reasons, I would even argue that a high trading frequency reduces your likelihood of beating the market over long stretches of time. Practice doesn’t make perfect.
- Measuring Performance Incorrectly, and Against the Wrong Benchmark
If an equity investor made a +15% return in 2019 and felt very confident with that result, my first question would be: what was your benchmark in 2019? If the benchmark was the S&P 500 index, then +15% is not a very good return. The S&P 500 was up +31.49% last year!
Going even further, investors often fall into the trap of measuring performance against a benchmark each year. But one good year is not necessarily the mark of a good investor. The best active investors outperform their benchmarks over long stretches of time, 10+ years or more.
There’s also the matter of individual investors failing to correctly measure their performance in a given year. Dr. Statman references a study of members of the American Association of Individual Investors, where participants “overestimated their own investment returns by an average of 3.4% a year relative to their actual returns.” This study illuminates a classic case of confirmation bias: investors want to believe they are superior managers, and therefore inflate returns to confirm their beliefs.
- Overconfidence Clouds Judgment
Have you ever bought a stock that went way up, and felt like a genius afterward? Don’t worry, that’s part of every investor’s story at some point in their lives. The question is, are you able to check yourself in those situations, to avoid associating a few good trades with being a brilliant investor?
Overconfidence tends to lead to more trading, which as I mentioned earlier, is a recipe for underperformance, in my view. Overconfidence also causes investors to shun or outright ignore risk, since ‘gut instinct’ outweighs fundamental research or a disciplined investment process. Too much confidence in the investment process can create blind spots.
- Faulty Strategies with Limited Information
Self-directed investors often process decisions by only using information that is already in their minds, or with information heard or read on the news. But that means making decisions on information that is incomplete or already priced into the market – or both. Similarly, investors often flock to stocks that are garnering a lot of attention in the media, a bad strategy that needs no explanation in my view.
Dr. Statman uses the “52-week” strategy as an example of an unproven method that many investors use, i.e., buying or selling a stock based on whether it is at the low end or the high end of a 52-week average price. The problem is, stocks are not beholden to these 52-week channels – there is nothing stopping them from shooting through a 52-week high or plunging much further below a 52-week low. Investors are trading faulty strategies with limited information.
Bottom Line for Investors
A Fidelity survey of amateur investors – when asked why they trade on their own – found that over 50% did it for “the thrill of the hunt,” or because they enjoyed the challenge and enjoyed sharing news with friends and family.2 But when asked if self-directed investors’ goal in trading is to “safeguard retirement,” the affirmative responses go way down. Think about that for a moment.
Our aim here at Zacks Investment Management is applying our disciplined, proprietary, repeatable, and notable investment decision-making process to deliver attractive long-term results to our clients. We strive to strip emotion out of our process completely, account for all of the biases above, avoid them at all costs, and focus on the hard data. That’s why many of our strategies are top-ranked by Morningstar,3 why our focus is on delivering attractive long-term results. In other words, we’re all seeking to “safeguard retirement,” and no “thrill of the hunt.”