How to Become a Better Investor
By R.Kevin O'Keefe, CIMA®, AIF®
The key is to separate your emotions from your investment decisions.
Becoming a better investor is about taming your emotions, not about fancy math or being able to predict the future. Here are five techniques to help you improve your investment behavior—and have more peace of mind.
- Less activity is better. In many areas of life activity is indicative of progress, but not so with investing. Trading is costly, and rarely leads to superior results. Just because there is a stock market, and people can trade does not mean they should.
- Remind yourself that market conditions change. Current trends do not persist indefinitely. Acting as if what has been happening recently will continue is one of the worst mistakes an investor can make. Many investors are tempted nowadays to invest in large U.S. stocks, because that has been the best-performing asset class for the past several years.
The fact is that markets tend to revert to long-term trends. When an asset type outperforms its long term average, don’t be surprised when the trend reverses and it underperforms for a while. It’s merely reverting to its long-term trend. One effective solution to “recency bias” is asset allocation with periodic rebalancing. Rebalancing is a disciplined way of buying low and selling high. Rather than shifting the allocation toward trends that have been in place for several months or quarters, allocate assets according to the investment policy you developed at the start of your investment plan, and follow through on rebalancing according to the rebalancing rules you established in your plan.
- Don’t own too much of your employer’s stock in your retirement plan. You need to diversify. If your employer contributes toward the cost of buying your company’s shares, great. Maybe you should take advantage of purchase incentives, provided you can unload these shares at full market price soon after you acquire them at a discount. But if you think you will know enough to sell the stock in a timely fashion because you’re close to the source, you are likely either fooling yourself or you may be inviting an insider trading indictment.
- Be honest in assessing your tolerance for risk. It is not a character flaw to have a limited tolerance for investment risk. Know yourself. Having a high tolerance for risk is easy when markets are going up and when you don’t have a lot to lose, or when you are many years away from needing to tap your nest egg. Just because you behaved well and slept well in the last market downturn does not mean you will do well in the next. Make sure you have the stomach for the volatility your portfolio is likely to produce. You want to make sure you’ll be able to resist the urge to change your plan in the midst of extreme market movements.
- Recognize when you are experiencing strong emotions. Whether you are exuberant or despondent—or somewhere in between—recognize the emotional state you are in. If you can recognize that you are afraid because the stock market just plunged, take that as an opportunity to reflect. Extreme emotional states predispose people to behave irrationally. Recognizing when you’re in such an emotional state will help you avoid making irrational mistakes.
Rule #1: Do not act in the heat of the moment. This rule does not apply in all areas of life, but it does apply to investing.
Rule #2: Reflect on your investment plan and your longer term goals. Remember that the plan was created to help you behave appropriately especially in times of stress. Have confidence in your plan; do not place your trust in your fears or in the doomsday predictions of so-called experts.
Rule #3: After your emotional state has quieted and you are able to think and behave rationally, evaluate your overall strategy and consider whether any revisions may be appropriate.
At First Affirmative, we understand that the ways we save, spend, and invest can dramatically influence both the fabric and consciousness of society. We believe that in addition to the benefits of ownership, investors bear responsibility for the impact our money has in the world. Are you making conscious decisions about the impact of your consumer purchase and investment decisions?
Mention of specific companies or securities should not be considered an endorsement or a recommendation to buy or sell that security. Past performance is no guarantee of future results.
Posted: April 15, 2015