Morningstar director of personal finance Christine Benz recently interviewedJason Zweig, author ofYour Money and Your Brain, about the latest thinking in behavioural economics, a field that examines the intersection of psychology and financial situations.
Psychology plays into many well-documented--yet surprisingly still common--investing mistakes. While advice like "buy low, sell high" strikes most investors as painfully obvious, there is still a great deal of buying high and selling low. Why? According to Zweig, it's the way we are wired.
But despite the brain's hardwired hang-ups, there are certain steps you can take to help dodge the pitfalls. Below are common portfolio mistakes, and tips to overcome them.
Trading too often
If you constantly check your portfolio, you will be tempted to take action at the slightest hiccups in your holdings or in the market. Limit the number of times you even look at your portfolio and set a schedule for rebalancing. At most, rebalance quarterly. Setting a guideline for yourself ahead of time will help you stay disciplined and will save you money on transaction fees.
Failing to rebalance
The opposite extreme is also problematic. If you don't check up on your portfolio and rebalance, you can end up with a substantially different risk profile than you intended. Your portfolio will be skewed to areas of the market that have performed well in the past and will be underweight in areas that have lagged. Check your portfolio at least once per year, but only rebalance if your allocations are significantly off.
Being unwilling to sell
This error can happen with either a stock that is performing well or a stock that has underperformed. When stocks are rising, it's understandable that you want to hold them in case they continue going up. After all, you rationalize, why would I sell now if I can hold it a while longer and possibly see an even higher return? But this creates a situation in which the present never looks like the right time to sell, and you end up never taking profits. When selling, think about whether it is a good time to sell, not whether it is the best time to sell.
On the other hand, if you purchased a stock that has languished in your portfolio, the natural tendency can be to hold on to it and try to at least break even. The problem? It might never happen, and waiting it out ties up money that could be deployed in other, more promising investments. Be prepared to acknowledge when the story has fundamentally changed, and know when you need to cut your losses.
Buying what's "hot"
An easy way to end up in the above situation is buying a company or sector when it's all the rage. A good sign something is set to fall? It is being discussed everywhere you turn as the next great investment. Many media outlets hailed tech stocks as the next best thing all the way up to the dotcom collapse in March 2000, and that missed call was not an aberration. For a pointed look at media insight (or lack thereof), read this article.
As Zweig says, "whatever feels the best to buy today is likely to be the thing you'll regret owning tomorrow." Investors tend to pour money into funds after they've performed well and rush for the exits after they underperform, resulting in much lower returns (or even losses) for average investors compared with funds' reported returns.
The bottom line: Beware of groupthink.
Ignoring expenses
Failure to look at mutual fund expense ratios can cost you precious percentage points in returns. Research in the United States has shown that funds with the lowest expense ratios also tend to outperform over time. Morningstar's director of mutual fund research Russel Kinnel explains: "Over a 10-year span, stock funds whose annual expense ratios are among the cheapest 20% in their categories are 1.4 times more likely to outperform and survive those in the second-cheapest quintile. And the least-expensive funds are 2.5 times as likely to outperform and survive those with expenses in the highest 20% of their categories."
Looking at your accounts in isolation
It's easy for your investments to become messy over the years as you spread your money between your RRSP, TFSA and taxable accounts. Of course, different accounts may serve different purposes, and you may be more aggressive in some than others. But holding dozens of investments in several different accounts earmarked for the same goal can be problematic. Your overall allocation may be different than you realize, and you will probably have overlap between funds and stocks.
You can see your investments as a whole by creating a combined portfolio on Morningstar.ca. Use the Portfolio X-Ray tool to see your overall asset allocation and the combined weight of all your holdings. You may have higher exposure to a particular asset class or sector than you realize.
A version of this article appeared on Morningstar's U.S.-based Web site, www.morningstar.com, on Jan. 20, 2010.
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