Investor Health Check - Part 1 of 3

Are you suffering from any of these common investor blind-spots?

Daniel Kahneman is an eminent psychologist and Nobel laureate, notable for his work on the psychology of judgment, decision-making, and behavioral economics.

He has conducted a number of studies and written numerous articles about the psychology of investment decision making.

Here, in this Three-Part series, we provide a check-list of 5 common 'blind-spots' suffered by investors that will jeopardise long-term investment success.

Mr or Mrs Investor, it's time for your check-up ..

1. Narrow Framing

Most people frame decisions narrowly, considering each one in isolation, instead of viewing each decision in terms of its broader context.

When thinking about financial matters, they often keep separate mental accounts.

For investors, this is commonly displayed in decisions that focus on a particular investment.

Let's say for example that a person invests in "A", with a firm conviction of its potential. Unfortunately "A" halves in price.

A typical reaction is that the investor feels compelled to invest further amounts in "A", hoping for a turnaround, despite changing investment fundamentals and without considering alternative options for their capital e.g. investment "B", or "C", or "D" etc.

The motivation here is a desire to have a "win" in relation to their chosen investment. That is, to avoid a loss on that particular investment, without considering alternative options that may now have greater potential for increasing their overall wealth.

Investors would make more effective decisions if they thought in terms of the overall wealth impact of their decisions and options.

This can be as simple as pausing before any action and asking a simple question:

"If I had the equivalent amount of money in cash today, is this an investment I would choose to make today given all the alternatives?"

Narrow-framing by investors is commonly evident in the following:

Having a greater sensitivity to losses, even small losses, than to gains of the same or greater magnitude. Investors will often focus on the 'one' investment that has lost value, than the 'three' that have gained in value.
Taking more risk and/or placing more importance on their investments outside of super than within super.

Just think about how many people trust their retirement savings to a default employer or industry fund, without a second thought about who is managing their money, what process they take, what the risks are, and what incentive the fund managers have to protect their investors.
Placing more confidence in investments that are 'popular' or receive positive news in the media.

We experienced this as advisers with BHP throughout 2007. A number of our clients could not understand why we were not recommending BHP as a buy at $40+. As the price advanced toward $50 the scrutiny only intensified. The 'big Australian' was on everybody's shopping list. With the subsequent price decline of BHP, some of those same clients now recant stories of their mates who have nearly lost everything by over-leveraging in BHP and are thankful for our disciplined advice.
Willing to take more risks with proceeds of a windfall gain or inheritance.
Focusing on the tax deductibility of an investment (i.e. the potential to gain back part of each dollar spent) rather than the quality of the investment (i.e. the potential to lose the whole dollar!).

2. Short-term Anxiety

When making an investment decision, people tend to ignore the likelihood that they will have more opportunities to invest in the future.

This often causes them to 'over-commit' capital to current investment opportunities for fear of missing out when they think it is 'the right time'.

Interestingly, the same short term focus will often 'unnerve' them if that investment falls in price over the following months.

There has never been a more conducive environment than the current time-period for this potential investor blind-spot. With the market displaying relief-rallies from a very low base, it is easy to jump in head first for fear of missing the 'great post-GFC rally', and having unrealistic expectations of rapid growth.

Over long periods, risky assets such as shares generally provide higher returns than low risk money in a bank deposit.

However, risky assets are called 'risky' for a good reason: their price direction is uncertain. They may produce losses over short periods, even though they are likely to produce higher returns than low risk assets in the long term.

It is important that investors allocate their 'limited capital' prudently by looking at their overall portfolio as a series of investments over time. This may mean averaging their entry prices through multiple purchases, and at times this will mean letting investments pass them by.

We try to maintain this disciplined approach at Eden.

At all times, this means the investor must focus on the long term and trust that new opportunities, and risks, will always be around the corner.

The greatest investor in the world, Warren Buffett, puts it this way:

"I call investing the greatest business in the world because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! and nobody calls a strike on you. There's no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it."

We hope that Part-One of this Three-Part series provided some insight into the psychology of the average investor and perhaps some personal insight that will change the way you approach investing for the future.

Join us in the next issue of the Eden Wealth Report for Part 2 of the "Investor Health Check".

Daniel Kahneman - Nobel laureate

Daniel Kahneman is an eminent psychologist and Nobel laureate, notable for his research and insight into the psychology of judgment, decision-making, and behavioral economics.

His body of work is fascinating, and you can read more about Daniel at the Nobel Prize offical website.

Below is an extract from Daniel's autobiography:

"In one experience I remember vividly, there was a rich range of shades. It must have been late 1941 or early 1942. Jews were required to wear the Star of David and to obey a 6 p.m. curfew. I had gone to play with a Christian friend and had stayed too late. I turned my brown sweater inside out to walk the few blocks home.

As I was walking down an empty street, I saw a German soldier approaching. He was wearing the black uniform that I had been told to fear more than others - the one worn by specially recruited SS soldiers. As I came closer to him, trying to walk fast, I noticed that he was looking at me intently. Then he beckoned me over, picked me up, and hugged me.

I was terrified that he would notice the star inside my sweater. He was speaking to me with great emotion, in German. When he put me down, he opened his wallet, showed me a picture of a boy, and gave me some money. I went home more certain than ever that my mother was right: people were endlessly complicated and interesting."

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