Several key reasons why we lose money
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Before making investment decisions, both investors and investments managers should keep their cool and “switch to decaf”
Speidell was in
In an interview with the Financial Mirror, Speidell outlined several classic ways in which investors lose money.
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Self-deception: “I’m above average”
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“Behavioural finance is all about why we do things with our money which afterwards we wish we hadn’t done when we really think about it,” he said.
One of the first mistakes we make as investors is self-deception.
Speidell referred to research conducted to test people’s beliefs about their own driving abilities.
“Eighty-eight percent of people surveyed in the
Of course, it is impossible for 88% of all drivers to be above average.
Speidell says that self-deception is particularly the case among investment professionals.
“Self-deception takes many different forms…we are over-confident in the lottery numbers we choose, we are over confident in the stock-picking ability we’ve got, we are over-confident in the patterns we see when we look at stock prices.”
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Impact bias: life will be great when I have …
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Two other forms of self-deception are impact bias and empathy gap.
In the impact bias, “You see something that you want – it can be a stock or an article of clothing – and you imagine how wonderful life will be once you’ve got it,” said Speidell.
The empathy gap is what happens when you lose your nerve about a rational investment decision.
“It’s the difference between our cool-headed analysis and what we actually wind up doing in hot blood. We make asset allocation decisions, for example. Suddenly markets gyrate wildly and we want to sell the ones that have gone down and buy the ones that have gone up and we forget all about our asset allocation.”
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Over-simplification: the law of small numbers
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Another classic reason why investors lose money is what Speidell calls the “law of small numbers” or “if it happened to me it’s important”.
This occurs when, for example, someone swears never to buy another internet stock again because they personally lost money on it the previous time.
“That’s a bad rule but people use it all the time.”
One subcategory of over-simplification, says Speidell, is familiarity bias.
Speidell noted that most people not only invest most of their money in the country in which they live, but they also invest most of it in the company they work for, often in the form of pension funds.
They also tend to think that this is a safer form of investment than alternatives.
“Of course, they are forgetting completely diversification,” he said.
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Losses are 2.5 times more painful than gains
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Speidell says that loss-aversion, “a psychological defect we all have”, is another form of over-simplification.
If offered a bet on a coin-toss for a 100 pounds win or lose, most people would not go for it.
But they would go for the bet if it were a 250 pounds win, 100 pounds lose.
“Which is to say that losses are 2.5 times as painful as gains: the loss of 100 pounds is a painful as a gain of 250 pounds,” said Speidell.
Since psychologically, losses have a greater impact on us than gains, investors often sell their winners and hang onto their losers instead of waiting for the longer term.
This is particularly the case with stocks, because unlike property, they are priced every day.
“It’s only when you look at stocks over 25-year periods that you realise that they outperform everything else on the planet [including property],” he said. Speidell noted that this has been shown to be the case not only in the
Therefore the idea that stocks are wilder than other assets is just the public’s perception, he notes.
It also implies that apart from having some “doomsday” protection, it is a mistake to switch to bonds in late middle age.
“If you have an investment horizon of 25 years, there is no reason to own bonds. Your return will always be higher in stocks,” he said.
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Group behaviour
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Another classic mistake made by investors is group behaviour. Speidell noted that it is a phenomenon that is still not properly understood but the usual features are that the soon-to-be fashionable asset starts by having a certain air of mystique about it. No one quite understands it.
This is followed by a perception that the smart people are doing it, followed by a rush to buy when people are afraid that “the train is leaving the station”.
Recent examples of group behaviour would be any stock relating to oil and gas.
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Agency risk
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For investment professionals, two specific investment mistakes are caused by the tendency to be attracted by form rather than substance, and the fear of career failure.
In the context of investment funds, they often go for the person with the best presentation, rather than the one that has the best results that come out of due diligence tests.
“If the presentation is stirring or motivating, they hire the man. They throw away all the data,” said Speidell.
Investment professionals are also keen to preserve their reputations, even if it implies lower investment returns.
“They would rather fail conventionally than succeed unconventionally because the peril of failing conventionally is career risk, and for an agent career risk is much more important than investment return,” said Speidell.
This makes managers “do things which they think are safe and cautious, even if things that are bold are diversifying.”
Many Cypriot provident funds, invested mainly in cash, are a classic example of this.
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Advice for investment professionals
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Asked how investment managers can avoid such pitfalls, especially when clients may be calling every day wanting to know about the latest hot stock, Speidell said
“Our job is not what our clients tell us our job is. Our job is not to pick the latest stock, hot fund or hot idea for them. Our job is to persuade them to do the right thing and stick to it in terms of diversification and asset allocation.”
Portfolios should be checked every five years not every five minutes, clients need to be reminded in the good times that these will not last, and the investment adviser needs to keep to the decisions made in a calm frame of mind.
“You sing the mantra: patience patience patience. … And you switch to decaf,” Speidell advises.
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Mary Curran
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