Behavioral Finance

Smarts Won’t Save You

Anyone and everyone is prone to common investing mistakes.

Book smarts aren't mistake-proof. Photo by inarik/IStock by Getty Images

Last month, a story on Bloomberg made the rounds: A tech worker in San Francisco named Chris,[i] fearful of Donald Trump winning the election, shifted his entire retirement portfolio into Treasury Inflation-Protected Securities (TIPS). His logic: Trump could "cause a depression," so it was best to play it "safe" until clarity arrived.[ii] Unfortunately for Tech Worker Chris, he got slammed in a couple ways: Not only did Trump win, stocks rose in the election's immediate aftermath. This is a vivid reminder: When cool heads prevail, it is easy to understand the logic and rationale behind staying invested during bumpy times. But when push comes to shove, actually doing so is extremely difficult. There isn't much you and I can do now to assuage our techie friend's pain. But you should make Tech Worker Chris's pain your gain by learning the investing lessons his experience highlights.

Blinding, Blinding Biases

It's easy to craft a world that conforms to your point of view, rather than seeing it as it is: a fallacy known as confirmation bias. To use Tech Worker Chris's story, let's say you think President-elect Trump is the antichrist. You would probably find arguments criticizing Trump's potential policies convincing-after all, the antichrist is very bad, so any decision he makes would naturally be disastrous. However, if you restrict yourself only to analyses you agree with,[iii] you may overlook or outright ignore contrary viewpoints (e.g., Trump wouldn't bring disaster because the president's power is limited), leaving you with a limited perspective.

Fear of an incoming president isn't exclusive to Trump. Many folks of the opposite political persuasion have held the same exact opinions and concerns about President Barack Obama since he was elected in 2008. Yet the world didn't end. A bull market began in March 2009, and the present economic expansion began that June. Both are still soldiering on today.[iv] This isn't because President Obama was "good" for economic growth or stocks. Economies are just much, much larger than any single US politician. And the US president has much less influence on the economy and markets than many think. Trump will face the same constraints as his predecessor, so however you personally feel[v] about the man, the Donald won't be able to do more than any other president, popular or no. Finally, there is the little matter of how markets work: Stocks move most on the difference between reality and expectations. If it turns out Trump's presidency is anything from less bad to benign-or even actually good-the positive surprise could send stocks surging. This is why it is vital to put biases (especially political ones) aside when it comes to investing.

Don't Shun the Mistake. Embrace It.

If you make a "mistake" in investing, don't pretend it didn't happen or seek a scapegoat-admit it, accept it and learn from it. In his book The Only Three Questions That (Still) Count, Ken Fisher said the most basic trick to becoming a better investor is to shun pride and accumulate regret, the very inverse of our natural tendencies.[vi] It isn't easy to override our instincts. We human beings are prideful creatures, loath to admit we are wrong about anything.[vii]

To test this, answer the following: What was the last good investment decision you made? Consider how quickly your answer came to mind. Easy, right? Probably felt good too! The decision shows off your smarts, since few saw the opportunity you did. At the holiday parties this year, you probably can't wait to tell everyone this story.

Ok, next question: What was the last stinker? This one may take a little longer to remember, as you've probably pushed it to some deep, dark recess of your mind. Heck, you probably weren't at fault, either. Your rationale was sound, but some one-off externality nobody saw coming happened, ruining everything. Or it's your broker/neighbor/buddy's fault for recommending it. Or it's the company's fault for not foreseeing the problem. Oh, and friendly reminder: Not making a move is a decision too. Holding cash while waiting for the ideal buying time or failing to diversify a big allocation in a longtime holding can be costly.

It's easy to dwell on our good calls and ignore the bad ones, but being a successful long-term investor requires evaluating our successes and failures fairly. That means being introspective and honest with yourself, which can be difficult since our biases (see above) are so powerful. If you panicked and sold off like Tech Worker Chris in fear of a President Trump, do you blame the polls and doomsayers for being wrong and misleading you? Or, instead, do you learn that market fallout from well-known political events is frequently overrated (hello, Brexit!) and not a sound thesis to radically change your portfolio? We all make mistakes, from legendary money managers to folks who just opened a 401(K). The quicker we admit it and internalize the lesson for the future, the better off your portfolio will be. It would be a shame to miss the lesson such mistakes teach and risk repeating them.

You Have a Plan for a Reason

To combat these behavioral mistakes, investors should have a plan designed to reach their personal investment goals, fully aware short-term market volatility is a thing to endure, not avoid. It's common in the financial services industry to take a risk-based approach to investing-determining your portfolio's asset allocation based on factors like comfort with volatility and potential loss. However, this view overlooks the biggest risk of all: not reaching your specific investment goals. That's why, in my opinion, long-term, growth-oriented investors should first establish their personal goals and map out a plan on how to reach them.

That plan shouldn't rely on avoiding all or even any bear markets, either. If you see a big negative forming few others notice, one with the potential to wipe out trillions in global GDP, then it makes sense to exit markets to avoid the worst of the decline. However, stocks' long-term historical average of 9.9%[viii]includes bear markets-you needn't call every single bear market correctly to enjoy stocks' returns. How you move forward with that plan may vary, but having one, at the very least, helps ground you when volatility-or anticipated volatility-arises. More importantly, you know you have to stick with that plan, rather than change it based on your feelings at any given time.

Headlines screamed for investors to run and hide many times throughout 2016. Remember China fears that accompanied the correction in early 2016? And Brexit in June? And now Donald Trump's election? If the world seems especially topsy-turvy, you may trick yourself into thinking "it's different this time"-the four most dangerous words in investing. Tech Worker Chris from San Francisco[ix] fell prey to them, and it has cost him substantially in lost opportunity. Moreover, now he must face up to his fears and wonder whether he should buy back in. Let his loss be your gain. And if you find yourself in a similar boat as Tech Worker Chris, fret not! Smarts, experience and worldliness won't prevent you from making even the simplest investing mistakes. However, as a wise teacher once told me, imperfections are all part of the human condition. How we bounce back from those shortcomings is a story we all can enjoy.[x]

[i] No, I'm not writing from the "hypothetical friend that's really me" perspective.

[ii] Depression in the economic sense, not the emotional sense. I think.

[iii] Echo chamber, anyone?

[iv] Thanks Obama.

[v] And believe me, I know the man elicits many feels.

[vi] Ken noted that these natural tendencies stem from our cavemen days and are extremely helpful when trying to survive, but in investing, they are dangerous.

[vii] And I refuse to admit that I could possibly be wrong on this point.

[viii] Source: Global Financial Data, S&P 500 Total Return annualized average from 1926 - 2015.

[ix] Again, not me.

[x] We can also all enjoy a LOLcat or two.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.