“You are your own worst enemy” – This classic phrase is especially true in the area of investing and trading. Unless you are a trading robot, you will be subject to mental biases that creep into your investment decisions.
And yes, there ARE literally robots that trade! But that’s a topic for another day.
It’s not just regular retail investors who face this problem… even seasoned investment professionals are prone to these biases.
Investment decisions should be made in a rational manner. However, mental biases could cause investors to deviate from rational behavior, and hence lead to poor investment decisions and outcomes.
To counter our own mental biases, the most important step is to understand what kind of biases and errors you would likely be prone to commit, so the next time you make an investment decision you just might be aware of these before hitting the BUY or SELL button!
A useful framework here is the Pompian Behavioral Model, developed in 2008. This framework classifies investors into 4 distinct behavior types, each with their own set of investing behavior.
Read on and see if you are 1 of the 4 investor types!
1) Passive Preserver
Risk Aversion and Conservative Style
The Passive Preserver is the most risk-averse of the four types. The main and most important objective of this type of investor is to preserve capital above all else.
Hence their investment style is usually very conservative, preferring investments which are unlikely to lose the initial capital invested.
Possible Strategy If You’re A Passive Preserver
A common issue faced would be an irrational fear of taking on investment risk when required. You would tend to have your assets kept in the form of “safe” investments where there is a low likelihood of capital loss and low price volatility.
Examples of such investments would be cash deposits, fixed deposits, investment grade sovereign bonds and low yielding investment grade corporate bonds.
Understand that even “safe” asset classes would perform badly under certain market conditions. Cash, for example, gets its value hammered during periods of high inflation rates. Diversify a portion of your assets into stocks (after careful analysis of course).
2) Friendly Follower
Investing with the Herd
The Friendly Follower tends to invest along with the crowd and in popular investments. While this is not totally a bad strategy (the crowd could be right), the investments made might not be suitable for the investor’s individual risk tolerance and investment objectives.
For example, a young investor might prefer to have a higher exposure to stocks in line with a higher risk tolerance. But recent popular listings of corporate bonds “convinced” the investor into investing in bonds instead.
Possible Strategy If You’re A Friendly Follower
Before making an investment decision, ask yourself whether it is based merely on recommendations of a friend or on the news, or if the decision is backed by reasonably done research. Also ask yourself if it fits your overall investment strategy.
For example, if investing in shares of a company, ask yourself questions about the fundamentals of the company and whether you have a “fair value” of the company in mind.
Is the company profitable? How profitable versus its competitors? How are the financial ratios like? Is the sector that the company is in doing well?
3) Independent Individualist
Actively Researches and Invests
The Independent Individualist prefers conducting research independently, relying on their own abilities to derive fair values of company shares or financial instruments and using a variety of other tools to make investment decisions.
They usually have moderate to high risk tolerance and would willingly take risks to gain wealth. They also tend to be the opposite of the Friendly Follower, preferring not to follow the crowd.
The danger here is that the investor might be using investment tools in the wrong way and hence make the wrong investment decisions.
Possible Strategy If You’re An Independent Individualist
Get secondary (or more) opinions on your investment research to check for flaws in your research process or methods used. One way to do so is to read research reports from banks or investment firms and see how they compare with your own analyses.
4) Active Accumulator
The Active Accumulator has an even higher degree of independence as well similar to the Independent Individualist. However the difference is they tend to do so while ignoring alternative opinions, even if these opinions are valid. They are also likely to have aggressive risk-taking behavior, usually at an emotional level.
Possible Strategy If You’re An Active Accumulator
Be aware that you might be making risky investment decisions on an emotional basis rather than objective research. Then you might want to consider keeping your hands off your own investments and let a qualified investment professional manage your funds for you.
Note that sometimes a combination of these types might be found in an investor. For example an investor might be an Active Accumulator with his CPF monies but a Passive Preserver with his own cash monies.
While it may not always be easy to control your own biases, it does help if you are aware of your own biases so the next time you decide to invest (or not to invest) in something you would be reminded that what you think is the best decision might not be what is good for you!
[featured image credits: www.wisdomtimes.com]