A flaw that pushes brilliant people to make financial mistakes

Avoiding investment mistakes

Chapter 9 of my new book, How to Make Money in ISAs and SIPPs, has proved to be very popular. So I thought it best to run a series of articles taken from the chapter to see what you think. This is article number two in the series.

As I’ve mentioned in a previous post, I’m proud to say that David Mountain, an ISACO client and engineer was one of the many people that loved this chapter.

In his review, David said:

“I guess the part of the book I most enjoyed was ‘Chapter 9: Beyond Greed and Fear’ – I found myself saying ‘that’s me’ and I can fully recognise this behavioural finance, which is a very interesting subject. I would rate the book with 5 stars. “

David wasn’t the only person to like Chapter 9. Ray Hughes, another ISACO client, entrepreneur and private investor said:

“I was delighted to see that Stephen also covered the psychology of investing within Chapter 9. In my opinion, as a more seasoned investor, this is one of the critical aspects that an investor must understand if they are going to be successful in the markets.”

Another person who loved that chapter Andrew Tait, a business owner and client of ours had this to say about it:

“I particularly enjoyed Chapter 9 on investor behavior, seeing my past self in the descriptions of how we can act irrationally when investing.”

Would you like to join these early reviewers of How to Make Money in ISAs and SIPPs? To download a ‘review copy’ – for free – prior to its publication, please just click here.

Excerpt below taken from Chapter 9, How to Make Money in ISAs and SIPPs

The winner's curse

One assumption found in finance and economics is that investors and traders are rational enough to be aware of the true value of an asset and will bid or pay accordingly. However, anomalies such as the winner's curse – a tendency for the winning bid in an auction to be higher than the true value of the item purchased – suggest that this is not the case. Rational-based theories assume that all people involved in the bidding process at an auction will have access to all of the relevant information and will all come to the same valuation.

Any differences in the pricing would suggest that some other factor, not directly tied to the asset, is affecting the bidding. According to Robert Thaler's 1988 article on the winner’s curse, there are two primary factors that weaken the rational bidding process: the number of bidders and the aggressiveness of the bidding.

For example, the more bidders involved in the process means that you have to bid more aggressively in order to put others off from bidding. Unfortunately, increasing your aggressiveness will also increase the likelihood that your winning bid will exceed the value of the asset.

Anchoring

Just as a house should be built upon a good, solid foundation, our ideas and opinions should also be based on correct facts in order to be considered valid. However, this is not always so. Anchoring is one of the root psychological flaws that pushes otherwise brilliant people to make financial mistakes and causes individuals to cling to a belief that may or may not be true, and to base their decisions for the future on that belief.

The inactivity that this leads to can have negative effects on their retirement accounts. For instance, if people anchor themselves to the belief that the stock market will keep going up, they will not only suffer from inactivity, they’ll be putting themselves at risk when the market eventually turns.

A diamond anchor

Consider this classic example taken from Investopedia.com: Conventional wisdom states that a diamond engagement ring should cost around two months worth of salary. This standard is a wonderful example of anchoring and illustrates why most of us make illogical and irrational financial decisions. While spending two months worth of salary can serve as a benchmark, it is a completely irrelevant reference point created by the jewellery industry to maximize profits, and not a valuation of love.

Many men can't afford to set aside two months’ salary towards an engagement ring while paying for living expenses. Consequently, a large number go into debt in order to meet the standard. In many cases, the diamond anchor will live up to its name, as the prospective groom struggles to keep his head above water in a sea of mounting debt.

Although the amount spent on an engagement ring should be dictated by what a person can afford, many men illogically anchor their decision to the two-month standard. Because buying jewellery is an unusual experience for many men, they are more likely to purchase something that is around the standard, despite the expense. This is the power of anchoring.

Common mistakes investors make

One anchoring behaviour that presents itself amongst investors is a reluctance to part with poorly performing investments. Often investors will cling to an investment, waiting for it to break even and get back to the price they paid for it. To avoid this happening, ask yourself: would I buy this investment again? And if you wouldn't, why are you continuing to own it? Another example is when investors focus too closely on their investment performance.

For example, if their portfolio has gone from £100,000 to £120,000 over the past year, they are happy. However, if during that twelve months their portfolio rose to £150,000 before dropping back to £120,000, they are upset. People mistakenly anchor to the high-water mark of their portfolios and are only satisfied when they hit an all-time high.

End of excerpt

As always, if you have any questions or thoughts on the points covered in this post, please leave a comment below or connect with us @ISACO_ on Twitter.

About ISACO

ISACO specialises in ISA and SIPP Investment and is the pioneer of ‘Shadow Investment’; an easy way to grow your ISA and SIPP at low cost. Together with our clients, we have an estimated £57 million actively invested in ISAs and pensions*. Clients like us because we have a great track record of ‘beating’ the FTSE 100**. Over the last 16 years, we’ve outperformed the Footsie by 60.2% and over the last 5 years, we’ve averaged 14.5% each year versus the FTSE 100’s 8.8%. You can find us at www.ISACO.co.uk.

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Picking the right fund for your ISA and SIPP is not exactly the easiest job in the world. And knowing 'when' to buy and 'when' to exit is even more difficult! Our ‘Shadow Investment’ Service is here to help. Our service allows you to look over our shoulder and buy the same funds that we are buying.

When we are thinking of buying a fund, we alert you so that you have the opportunity to buy it on the same day that we buy it. We also tell you about when we are planning to exit the fund. You control your investment account, not us. You can start small and invest as little or as much money as you like.

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*November 15^th 2012: Internal estimation of total ISA and pension assets owned by ISACO Investment Team and ISACO premium clients.
**Long-term performance: December 31^st 1997 - December 31^st 2013 ISACO 91.3%, FTSE 100 31.1%. 5 year performance: December 31^st 2008 - December 31^st 2013. ISACO Investment performance verified by Independent Executives Ltd.

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