Investment Pitfalls – Insights From Behavioral Economics

Over-confidence

Confidence is a good thing. But we are often outsmarted by the accidental nature of market movements. If we buy Nestlé shares today and the share price actually rises, we are quick to take the credit. But if it falls, we blame it on all sorts of other factors. The same applies to other asset classes. Ultimately, developed capital markets are really quite efficient, i.e., the information available is already priced into the market. That is why even professionals have trouble predicting prices. A portfolio should reflect your own convictions and market expectations. But the important thing is to ensure that it always remains diversified, i.e., it should not focus on individual asset classes (or even worse: individual stocks).

Gut feeling is often a poor financial advisor

Intuition is good. But when it comes to investing money, fears and hopes can often lead us astray. Capital markets are unpredictable and volatile, that is their nature. They go up and down all the time. Gains can quickly lead to euphoria, losses fuel fears. Both are dangerous. People who are driven by fear in an adverse market environment will invariably cut the asset allocation. Although this reduces the risk of further losses, it also curtails the potential to participate in the market recovery. In the long run, this is detrimental to long-term investment success. Conversely, when markets rally, investors tend to increase their allocations. Fine, if the trend lasts. But a problem, if the market starts to decline again. That is why your portfolio has to match your individual risk appetite and risk tolerance. To ensure that you can give your portfolio enough time to recover during difficult market phases.

Further reading

Daniel Kahneman, Thinking, Fast and Slow, 2011 (available from amazon, buch.ch, itunes).

Daniel Kahneman and Amos Tversky became famous for their research into cognitive biases, which ultimately led them to behavioral economics. After Tversky's death, Kahneman was awarded the Nobel Prize in Economic Sciences in 2002.

Our recommendation

Although at True Wealth we deduct the transaction fees from our asset management fee, we recommend that you do not change your asset mix too frequently, because the price spread will lower your return a little every time you change your portfolio. Review your risk profile at least once a year, or whenever your financial situation changes. To do so, log in under your user name and adjust your risk profile (under Login > Account settings > Risk tolerance > Re-determine risk tolerance).