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.

  1. 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.

  1. 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.

  1. 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.

  1. 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.”

Disclosure

1 The Wall Street Journal, February 9, 2020. https://www.wsj.com/articles/the-mental-mistakes-that-active-investors-make-11581304440?mod=hp_listb_pos1&mod=article_inline

2 The Wall Street Journal, February 9, 2020. https://www.wsj.com/articles/the-mental-mistakes-that-active-investors-make-11581304440?mod=hp_listb_pos1&mod=article_inline

3These rankings may not be representative of any one client’s experience. In addition, they are not indicative of future performance

DISCLOSURE

Past performance is no guarantee of future results. Inherent in any investment is the potential for loss.

Zacks Investment Management, Inc. is a wholly-owned subsidiary of Zacks Investment Research. Zacks Investment Management is an independent Registered Investment Advisory firm and acts as an investment manager for individuals and institutions. Zacks Investment Research is a provider of earnings data and other financial data to institutions and to individuals.

This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional legal, tax, or accounting counsel. Publication and distribution of this article is not intended to create, and the information contained herein does not constitute, an attorney-client relationship. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of herein and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole.

Any projections, targets, or estimates in this report are forward looking statements and are based on the firm’s research, analysis, and assumptions. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and other sources may be required to make informed investment decisions based on your individual investment objectives and suitability specifications. All expressions of opinions are subject to change without notice. Clients should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed in this presentation.

Certain economic and market information contained herein has been obtained from published sources prepared by other parties. Zacks Investment Management does not assume any responsibility for the accuracy or completeness of such information. Further, no third party has assumed responsibility for independently verifying the information contained herein and accordingly no such persons make any representations with respect to the accuracy, completeness or reasonableness of the information provided herein. Unless otherwise indicated, market analysis and conclusions are based upon opinions or assumptions that Zacks Investment Management considers to be reasonable. Any investment inherently involves a high degree of risk, beyond any specific risks discussed herein.

The S&P 500 Index is a well-known, unmanaged index of the prices of 500 large-company common stocks, mainly blue-chip stocks, selected by Standard & Poor’s. The S&P 500 Index assumes reinvestment of dividends but does not reflect advisory fees. The volatility of the benchmark may be materially different from the individual performance obtained by a specific investor. An investor cannot invest directly in an index.

Returns for each strategy and the corresponding Morningstar Universe reflect the annualized returns for the periods indicated. The Morningstar Universes used for comparative analysis are constructed by Morningstar (median performance) and data is provided to Zacks by Zephyr Style Advisor. The percentile ranking for each Zacks Strategy is based on the gross comparison for Zacks Strategies vs. the indicated universe rounded up to the nearest whole percentile. Other managers included in universe by Morningstar may exhibit style drift when compared to Zacks Investment Management portfolio. Neither Zacks Investment Management nor Zacks Investment Research has any affiliation with Morningstar. Neither Zacks Investment Management nor Zacks Investment Research had any influence of the process Morningstar used to determine this ranking.