Posts Tagged behavioral finance
I just finished reading an excellent book, Reality is Broken: Why Games Make Us Better and How They Can Change the World by Jane McGonigal. The book draws on positive psychology, cognitive science, and society to describe how game designers have hit upon core truths about what makes us happy and have utilized these discoveries to astonishing effect. She analyzes many different types of games and demonstrates how using some of the key ideas of their design may help to address some of the world’s most difficult and intractable problems.
However, none of the profiled games in Reality is Broken specifically address the problems faced by the self-directed investor, so I thought it might be interesting and potentially enlightening if I probed the question: is investing a game? Read the rest of this entry »
Many investors’ existing portfolios are not well suited to accomplish their goals. But how does one determine whether a portfolio is well constructed or poorly constructed?
I have categorized the important elements into five categories. These broad categories are asset allocation appropriateness, diversification, security selection, investment decision-making process, and tax efficiency. These categories are not mutually exclusive, due to the subjective nature of the task and the fact that most investment decisions have a wide range of effects and consequences. Read the rest of this entry »
The stock market fell over 5% this past week, and the financial media reported half of the story. The headline article in Friday’s Wall St. Journal provides a classic example. Here is a sample quote: “Volume on stock exchanges has spiked in recent days, a sign that more investors are piling into selling.” The thrust of the article is that “everyone” is selling, “no one” is buying, and that is what is driving the market down. Most readers do not question statements like this. They should, because such statements are misleading at best and flat out wrong at worst. Read the rest of this entry »
Many mutual fund investors believe that buying the highest rated funds is a good way to invest. It actually is a very poor idea, and it is likely to lead to, at best, mediocre performance. Why? Because investors who buy such funds are buying at the wrong time. Read the rest of this entry »
When managing an investment portfolio, it is necessary to answer six straightforward questions. The questions are what to buy, when to buy, how much to buy, what to sell, when to sell, and how much to sell. All one needs to do is to have an adequate plan for answering these questions and the job is complete. When the task of investment management is framed in this manner, some of the drawbacks of the more common approaches are exposed. For example, if you read the financial press or check out the personal finance section of your local bookstore you will find a disproportionate amount of attention focuses on the first question, what to buy, and not nearly as much on any of the others. What to buy is important, but it is not really the most important driver of investment performance. The next two questions actually have more of an impact on overall performance. The “how much” questions are much more significant than the others, but get relatively little attention. Frequently, the answer to “how much” is the amount of “spare” cash lying around in an account. This is a rather shortsighted way to manage a portfolio and can result in being poorly positioned when market trends change and can also lead to over- or under- allocations to important asset classes. Investors who have not given ample consideration and attention to the “how much” question frequently are exposed to unnecessary amounts of risk due to their misallocated portfolios. Read the rest of this entry »
Is your investment success dependent on the unfolding of a specific set of future events, such as the direction of interest rates, inflation, or the global economy? Are you relying on particular companies to outperform their competitors for as long as you own their stock? If so, you may have a problem.
Have you ever critically examined the accuracy of those who claim to be able to divine the future direction of any market? You will find that the accuracy of such predictions is about the same as if you took a random guess. How many forecasters foresaw the depth and breadth of the recent financial crisis? The Federal Reserve did not see it coming. The manager of the largest mutual fund, Bill Gross, said two months before Lehman collapsed that “there was close to 100% probability that Lehman would avoid failure.” What makes this situation even worse is that the biggest forecasting errors occur when you need the information the most—right before a major turning point. Read the rest of this entry »
Two and half years ago, Apple stock was selling for around 90 dollars per share. Now it is above 300. If an investor put 75% of his wealth into Apple stock, would that have been a good investment decision? Many people would say so. Just look at the results. More than tripling your investment can’t be bad. The choice of individual investment does not matter for this example. I could have chosen Ford stock, junk bonds, gold bars, or Chinese ceramics. Many different assets appreciated at abnormally high rates over the last several years.
In spite of the success of this investment, I would argue that this was a shortsighted decision that happened to have a fortuitous outcome. Putting 75% of your wealth in a single investment is almost always a poor idea, no matter what happens subsequently. This investor got lucky. In 2011, he might have another great idea and put 75% of his now larger wealth into another investment, and it might not turn out so well. His process for making investment decisions has a fundamental flaw, and sooner or later, the laws of probability are bound to catch up with him and he will likely experience a very bad result. Read the rest of this entry »
As a long time market observer, one of the questions I am most frequently asked is: what do I think the stock market will do next? This question makes me wince. Why? Almost any answer I give is fruitless. I could give a very accurate answer, which is what J.P. Morgan did when he was repeatedly asked the same question many years ago. He said, “Prices will fluctuate.” I could be a little more specific and say, “On average, if history is any guide, prices will rise 20 out of the next 39 days and fall 19 of those days. The particular sequence is unpredictable and unknowable.” Or I could be ultra-specific and say, “The S&P 500 will rise by 4.2% in the next three months.” But why should anyone believe an answer as precise as that? Such predictions are no more than guesses, and even if you gathered a bunch of them from every market pundit, you would simply be taking a sample of the consensus, which may or may not turn out to be true. We know that such forecasts are about as accurate as rolling dice, so why even ask? Read the rest of this entry »