Avoiding the decisions that often lead to financial self-sabotage

Would you invest your money with a manager who didn’t know the names of any of the stocks in his portfolio, or the price they were purchased at? How would you feel if I told you the best way of boosting returns was to not consult your portfolio more than once a year?

Such ideas may seem unconventional, but behavioural finance experts suggest they will help investors avoid the dodgy decisions that too often lead to financial self-sabotage.

Money manager, author and finance professor Thomas Howard says the behavioural approach is the "next paradigm" for investment management. Investors must focus solely on a few specified criteria, he says, and eliminate emotions from the investing process. In his case, he focuses on dividends, earnings estimates, debt (the more, the better), and sales.

No-name strategy

Although he only holds around 10 stocks, he doesn’t know the names of any of them. He doesn’t know what the companies do. He doesn’t know what price they were purchased at, or what price they are eventually sold at. He simply looks at his criteria on a monthly basis, and instructs his traders to sell if a company fails on any one of them.

"I really don't know whether my stocks made or lost money", he says in the latest CFA Institute Magazine. "I follow the portfolio – I know it's going up – but I have no idea which individual stocks are going to make money or lose money."

Once he sells the stock, he never looks at it again, “but that’s pretty easy because I don’t remember it in the first place.”

The whole point is to not waste time on regret, and “ruthlessly” drive emotion out of the decision-making process.

It seems to be working – Howard’s Athena fund was the top-ranked portfolio in its category in the US last year, having soared 67 per cent, and has generated annual returns of 25 per cent over the last 12 years.

Now, one can argue Howard’s concentrated approach is risky, and therefore likely to generate either substantial outperformance or underperformance.

Loss aversion

However, the psychology underlying his approach is sound. Economist and behavioural thinker

Richard Thaler

likes to tell a story first related by Nobel economist

Paul Samuelson

, who once asked a colleague if he would accept a bet with a 50 per cent chance of losing $100 and a 50 per cent chance of gaining $200. The rational response would be to accept such a favourable bet, but he refused, saying he would “feel the $100 loss more than the $200 gain”.

Studies confirm this sensitivity to losses. It gives rise to the disposition effect, the tendency of investors to sell shares whose price has risen, and hold on to shares that have fallen in value.

By being unaware of the purchase price, Howard ensures that if a stock should be sold, it will be sold, even if it is at a loss; if it should be held, it will be held, even if this means losing the chance to take profits.

Obviously, Howard’s approach isn’t practical for most investors, who can’t help but be aware both of the stocks they own and the purchase price paid. The most feasible way of diminishing the role of loss aversion, Richard Thaler suggests, is to avoid looking at your portfolio.

The more a person checks their portfolio – and one can do so as often as one wishes, thanks to the internet – the more they will experience the pain of paper losses, Thaler theorised.

To test his hunch, he devised an experiment; one group could check its portfolio every month, another group could do so every year, and another group every five years. Sure enough, the frequent checkers whittled down their equity allocation to just 41 per cent, compared to 66 per cent for the group that checked least often.

Thaler's recommendations are echoed by Nobel economics winner Daniel Kahneman. "If owning stocks is a long-term project for you, following their changes constantly is a very, very bad idea", he says. "It's the worst possible thing you can do, because people are so sensitive to short-term losses. If you count your money every day, you'll be miserable".

Unfortunately, most investors don’t heed this advice. Automated investing firm Betterment says just 10 per cent of customers log into their accounts less than once per month. Frequent checkers tend to be young, male, have a lower net worth and a higher balance. US research firm Dalbar, meanwhile, has found the average stock investor earned just 3.7 per cent annually over the last 30 years, compared to 11.1 per cent for the S&P 500.

“Investors tend to sell after experiencing a paper loss and start investing only after the markets have recovered their value”, says Dalbar. “The devastating result of this behaviour is participation in the downside while being out of the market during the rise”.

Institutional investors are little better. Hedge funds have justifiably come in for criticism in recent years, particularly since the publication of Simon Lack's The Hedge Fund Mirage. Lack noted the results would have been twice as good if all the money that had ever been invested in hedge funds had instead been put into US treasury bills. That's true, but it's partly because institutional investments in hedge funds peaked just before the global financial crisis. Research confirms pension funds buy in late and sell at inopportune moments, causing them to earn an average of at least three percentage points less than the hedge funds they are invested in.

Volatility is normal

Investors tend to get spooked by volatility, perhaps unaware just how normal it is. US markets have returned about 9.5 per cent annually over the last century. However, supposedly extreme years are more normal than they seem – in two-thirds of the years since 1926, stocks either jumped at least 20 per cent or fell by more than 10 per cent.

As Motley Fool and Wall Street Journal columnist Morgan Housel has noted, investors should roughly "expect stocks to fall at least 10 per cent once a year, 20 per cent once every few years, 30 per cent or more once or twice a decade, and 50 per cent or more once or twice during your lifetime."

Those of a nervy disposition would do well to avoid volatile lottery stocks and instead prioritise low-volatile blue chips (research indicates low-risk stocks are better for the wallet as well as the heart).

However, there's no escaping market volatility. Even Warren Buffett, who famously eschews volatile growth stocks, suffered four drawdowns ranging from 37 to 51 per cent between 1987 and 2009, or roughly one meltdown every five years.

Little wonder Buffett advises people avoid the stock market if they cannot watch their holdings halve in value without becoming panic-stricken.

Avoiding stocks, unfortunately, brings its own costs. Over time, the difference between a stock-heavy and a stock-light portfolio “is huge, possibly millions of dollars”, says Thomas Howard.

Perhaps the best course of action, then, is to follow Daniel Kahneman’s example. “I take my own advice”, he says. “I don’t look at my investments very often or not at all. Checking them too often is not good”.