The manner in which the human brain functions can cause you to think in ways that induce problems. For example, people use mental accountingto compartmentalize individual investments and categorize costs and benefits. While mental accounting can help you exert self-control to not spend money you are saving, it also keeps you from properly diversifying. The consequence is that you assume more risk than necessary to achieve your desired return.
To avoid regret about previous decisions that did not turn out well, the brain filters the information you receive. This process, called cognitive dissonance, adjusts your memory about the information and changes how you recall your previous decision. Obviously, this will reduce your ability to properly evaluate and monitor your investment choices.
The brain uses shortcuts to reduce the complexity of analyzing information. These shortcuts allow the brain to generate an estimate of the answer before fully digesting all the available information. For example, the brain makes the assumption that things that share similar qualities are quite alike. Representativeness is judgment based on stereotypes. Furthermore, people prefer things that have some familiarity to them. However, these shortcuts also make it hard for you to correctly analyze new information, possibly leading to inaccurate conclusions. Consequently, you put too much faith in stocks of companies that are familiar to you or represent qualities you desire.
This review of the psychological biases should help you with the first strategy of understanding your psychological biases. However, as Figure 15.1 suggests, knowing about the biases is not enough. You must also have a strategy for overcoming them.
"Y<m twz so stubborn,"
STRATEGY 2: KNOW WHY YOU ARE INVESTING
You should be aware of the reasons you are investing. Most investors largely overlook this simple step of the investing process, having only some vague notion of their investment goals: "I want a lot of money so that I can travel abroad when I retire." "I want to make the money to send my kids to college." Sometimes people think of vague goals in a negative form: "I don't want to be poor when I retire." These vague notions do little to give you investment direction. Nor do they help you avoid the psychological biases that inhibit good decision making. It is time to get specific. Instead of a vague notion of wanting to travel after retirement, be specific. Try
A minimum of $75,000 of income per year in retirement would allow me to make two international trips a year. Since I will receive $20,000 a year in Social Security and retirement benefits, I will need $55,000 in investment income. Investment earnings from $800,000 would generate the desired income. I want to retire in 10 years.
Having specific goals gives you many advantages. For example, by keeping your eye on the reason for the investing, you will
■ Focus on the long term and look at the "big picture"
■ Be able to monitor and measure your progress
■ Be able to determine if your behavior matches your goals
For example, consider the employees of Miller Brewing Company who were hoping to retire early (discussed in Chapter 11). They had all their 401(k) money invested in the company stock, and the price of the stock fell nearly 60%. When you lose 60%, it takes a 150% return to recover the losses. It could easily take the Miller employees many years to recover the retirement assets. What are the consequences for these employees? Early retirement will probably not be an option.
Investing in only one company is very risky. You can earn great returns or suffer great losses. If the Miller employees had simply compared the specific consequences of their strategy to their specific investment goals, they would have identified the problem. In this type of situation, which option do you think is better?
A. Invest the assets in a diversified portfolio of stocks and bonds
that will allow a comfortable retirement in two years.
B. Invest the assets in the company stock, which will either earn
a high return and allow a slightly more comfortable
retirement in two years, or suffer losses which will delay
retirement for seven years.
Whereas option A meets the goals, option B gambles five years of work for a chance to exceed the goal and is not much different than placing the money on the flip of a coin.
STRATEGY 3: HAVE QUANTITATIVE INVESTMENT CRITERIA
Having a set of quantitative investment criteria allows you to avoid investing on emotion, rumor, stories, and other psychological biases. It is not the intent of this book to recommend a specific investment strategy like value investing or growth investing. There are hundreds of books that describe how to follow a specific style of investing. Most of these books have quantitative criteria.
Here are some easy-to-follow investment criteria:
■ Positive earnings
■ Maximum P/E ratio of 50
■ Minimum sales growth of 15%
■ A minimum of five years of being traded publicly
If you are a value investor, then a P/E maximum of 20 may be more appropriate. A growth investor may set the P/E maximum at 80 and increase the sales growth minimum to 25%. You can also use criteria like profit margin and PEG ratio, or you can even look at whether the company is a market share leader in sales.
Just as it is important to have specific investing goals, it is important to write down specific investment criteria. Before buying a stock, compare the characteristics of the company to your criteria. If it doesn't meet your criteria, don't invest!
Consider the Klondike Investment Club of Buffalo, Wyoming, discussed in Chapter 7. The club's number one ranking stems in part from its making buy decisions only after an acceptable research report has been completed. Klondike's criteria have protected its members from falling prey to their psychological biases. On the other hand, the California Investors Club's lack of success is due partially to the lack of criteria. Its decision process leads to buy decisions that are ultimately controlled by emotion.
I am not suggesting that qualitative information is unimportant. Information on the quality of a company's management or the types of new products under development can be useful. If a stock meets your quantitative criteria, then you should next examine these qualitative factors.
STRATEGY 4: DIVERSIFY
The old adage in real estate is that there are three important criteria when buying property: location, location, location. The investment adage should be very similar: diversify, diversify, diversify.
It is not likely that you will diversify in a manner suggested by modern portfolio theory and discussed in Chapter 9. However, if you keep some simple diversification rules in mind, you can do well.
■ Diversify by owning many different types of stocks. You can
be reasonably well diversified with 15 stocks that are from different industries and of different sizes. One diversified mutual fund would do it too. However, a portfoilio of 50 technology stocks is not a diversified portfolio, nor is one of five technology mutual funds.
■ Own very little of the company you work for. You already have your human capital invested in your employer—that is, your income is dependent on the company. So diversify your whole self by avoiding that company in your investments.
■ Invest in bonds, too. A diversified portfolio should also have some bonds or bond mutual funds in it.
Diversifying in this way helps you to avoid tragic losses that can truly affect your life. Additionally, diversification is a shield against the psychological biases of attachment and familiarity.