Don't be weak

be patient and be rich

Dollars & Sense

December 14, 2003|By Brian Lund | Brian Lund,MORNINGSTAR.COM

Successful investing is hard, but it doesn't require genius. It does require the ability to identify and overcome one's own psychological weaknesses.

Behavioral finance has become a cottage industry in recent years, spawning academic papers and learned tomes that attempt to explain why people make financial decisions that are contrary to their own interests. Several mutual funds have even appeared, such as LSV Value Equity (LSVEX) and Undiscovered Managers Behavioral Growth (UBRLX), that seek to exploit faults in investor behavior.

The concept is not new. Benjamin Graham used to portray Mr. Market (and who is the market other than you and I?) as a fellow prone to mood swings, from wildly optimistic to irrationally pessimistic. The key for Graham - and for his disciple, Warren Buffett - is patience.

As Buffett said in a 1999 interview with Business Week, "Success in investing doesn't correlate with IQ once you're above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing."

Yet, despite all the warnings, investors continue to exhibit several key behaviors that tend to get them into trouble.

1. Checking prices too often.

I'm guilty here. I look at my stocks at least a couple of times a day, so I know firsthand what a psychologically painful experience it can be. The problem is that people are generally loss-averse - that is, they experience negative feelings from a $50 loss that are stronger than the positive feelings they get from a $50 gain.

This concept formed the basis for prospect theory, developed by Nobel laureate Daniel Kahneman and Amos Tversky in 1979. Richard Thaler and Shlomo Benartzi went the next step and showed that frequency of evaluation was key to how well an investor could endure losses. Those who do their mental accounting over short time spans, even if they're investing for the long term, earn lower returns.

Again, this is nothing new. Buffett has said that he wouldn't mind if the market shut down for years at a time. For many of us, though, every day becomes another chance to suffer the agony of our investment decisions.

Nassim Taleb, who runs a hedge fund, Empirica Capital, that makes its living by enduring short-term pain, points out in his book Fooled by Randomness that probability dictates that the market will show a positive return on only a little over half of the days it's open. If losses hurt twice as much as gains, then people who check their portfolios daily will suffer much more than they'll benefit.

Thaler and Benartzi calculate that the "psychic cost" of evaluating your portfolio on an annual basis is 5.1 percent per year, vs. 0.6 percent for a 10-year evaluation period, based on changes in the implied equity-risk premium. Measuring performance on a daily basis seems certain to drive the risk premium even higher, costing investors considerably more than 5.1 percent.

Do yourself a favor and try to resist the urge to calculate your portfolio value in real time. The quotes may be free, but the total cost can be huge.

2. Trading too often.

Terrance Odean and Brad Barber studied activity in 66,000 accounts at a large discount broker from 1991 to 1996 and came to this conclusion: "Trading is hazardous to your wealth."

They found that individuals who trade frequently (with monthly turnover above 8.8 percent) earned a net annualized return of 11.4 percent over that time, while inactive accounts netted 18.5 percent.

Trading costs, in the form of commissions and losses on the bid-ask spread, accounted for most of the difference. Those costs have likely fallen since 1996, as more discount brokers have pressured commission prices and decimalization has reduced spreads, but friction costs remain a drag on overall returns.

But surely investors got some benefit from trading less desirable stocks for better ones, right? Nope.

In fact, Odean and Barber found that, excluding transaction costs, newly acquired stocks actually slightly underperformed the stocks that were sold! That bears repeating: By trading frequently, individuals hurt not only their performance net of fees, but they also hurt their performance before fees.

Why would this be? Odean and Barber believe that it reflects investors' overconfidence in their ability to assess information. It's clear that rapid traders are making unreasonable bets - one would expect that they would trade only when the benefit would offset at least the cost of trading, but that was clearly not the case in this data set. But does high turnover reflect self-assurance, or could it betray the lack of it?

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