If you're like most people, you're probably indulging in a bit of yearend introspection as 2007 approaches. Chances are your investments are on your list of existential crises, right there alongside losing a few extra pounds and writing your memoirs. Maybe you're evaluating your sector or country positioning or even considering selling some of your dogs to harvest tax losses. Periodic evaluation of your investments is a good thing. But it's worth being aware of some common biases and traps investors fall into during this period of reflection.
- Focus on your total portfolio. Most investors fall victim to order preference, which means they want each part of their portfolio to perform well. If they are benchmarked to the S&P 500, for instance, they expect all 500 stocks to do as well or better than the benchmark. But this isn't the way it works. There are going to be stocks down 50% or even 80%, just like there are going to stocks up 100%. Happens every year. Your individual stocks will gyrate wildly and perform, by and large, similar to their respective categories. Don't be tempted to sell those losers just because they're down for the year. The total portfolio is what counts, not the individual parts.
- Stick to your benchmark. Following the roadmap of your benchmark is one of the smartest investment decisions you can make. If Energy is a 10% weight in the benchmark, don't put 50% in it just because you think it's going to grow like gangbusters. That's a dangerous amount of risk-taking. Have some humility, and always know you can be wrong. Even the most successful investor on the planet is wrong—a lot.
- Don't chase heat. The sectors and countries that are hot right now aren't guaranteed to be the leaders in the future. No one style, sector or country leads forever. Hindsight bias, a cognitive error causing investors to exaggerate the quality of their foresight, leads us to presume prior patterns persist. Don't blindly jump into the leaders. You're likely to get burnt.
- Be wary of overconfidence. Maybe you got lucky this year, and your portfolio did very well. Don't accumulate pride, though, as it directly leads to overconfidence. And that can lead to some silly investment decisions. The simplest, most basic trick to becoming a better investor is to shun pride and accumulate regret.
Feel free to take a step back this holiday season and evaluate what went right and wrong for you this year. Just remember you're brain is likely to try and trick you. And you don't want to do something with your investments that isn't prudent for your long-term goals and objectives. The more you can recognize these traps and pitfalls, the better investor you'll be next year. Now get to work on those memoirs.