Archive | Behavioral finance

The 50-Percent Solution

Investing can seem so complicated. Building a portfolio can involve dozens of decisions, each of which seems terribly important. Here are a few that readers have mulled over recently, according to emails I’ve received:

Should I use fundamentally weighted or traditional cap-weighted ETFs?
Should I hedge the currency in my US holdings?
Will dividend-focused equities outperform a broad-market ETF?
Short-term bonds or a broad-market bond fund?

All of these are thoughtful questions, but each involves a choice between two good alternatives: one is likely to turn out better over the long run, but there’s no way of knowing which one. And yet I regularly hear from readers who are sitting in cash—or worse, sitting in overpriced mutual funds—because they can’t decide which alternative to take.

There are lot of big questions in investing. Whether you use a stock-picking strategy or a passive Couch Potato portfolio matters a lot. Hiring an advisor or investing on your own will also make a dramatic difference. Dumping your GICs for high-yield bonds without understanding the risk? Definitely huge. Decisions like those above—where both alternatives are reasonable, and the superiority of one cannot be predicted—are much smaller.

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Investing Lessons From the Poker Table

This week I beat a group of seniors and took $200 from them.

No, I’m not a purse-snatching hooligan who preys on the elderly. I’m just a guy who loves to play poker, and on Tuesday I took a day off to visit the local casino, where I played poker at a table with several amiable older gentlemen. The experience got me thinking about how poker and investing teach many of the same lessons:

Short-term results are meaningless. I’ve played poker alongside some truly bad players who always seem to hit miracle straights or flushes and scoop big pots. When these players beat you, it can make you wonder whether you should be playing differently — maybe you should start playing more hands, or calling big bets with weak draws, since it seems to be working so well for that guy. Investors fall into this same trap when they second-guess the Couch Potato strategy during every period of poor returns. In both poker and investing, you need to stick to a proven strategy: you will succeed in the long run, even if you have to suffer streaks of bad luck.

Play the percentages,

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Review: Why Smart People Make Big Money Mistakes

To be successful with money, it’s not enough to have a good strategy. You also need to avoid the emotional and psychological traps that snare so many investors. Gary Belsky and Thomas Gilovich examine these pitfalls in their eminently readable book on behavioural economics, Why Smart People Make Big Money Mistakes (Simon and Schuster).

The book was originally published in 1999, but it has been extensively revised and updated. Of course, human nature hasn’t changed in the years since the book first appeared. See if you recognize yourself in any of these logical fallacies and psychological pitfalls:

Mental accounting. I admit I fell prey to this one when I opened a Tax-Free Savings Account to sock away some cash. I soon realized this made little sense when I was carrying a mortgage with an interest rate higher than what I would earn from my savings. So I closed the account and made a mortgage prepayment instead. Mental accounting makes you feel like you’re saving, even when you’re actually losing money by ignoring your debt. A similar lapse in logic occurs when we are reluctant to sell stocks inherited from a parent,

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Random Thoughts

The Toronto media is abuzz with stories about jaywalking. Over the last two weeks, 14 pedestrians have died while crossing the street in the Greater Toronto Area, a surprising rate of carnage in a city that sees about 30 pedestrian deaths in a typical year. “Why aren’t we talking about lowering speed limits, increasing penalties or narrowing city streets?” asked one outraged scribe in The Toronto Star. The Sun called the deaths “a worrying trend for safety experts.”

So what does this have to do with investing, you ask? It’s a classic example of our inability to accept randomness: the same human failing that compels us to ascribe a rational explanation to every move in the stock market.

Humans are hard-wired to explain things with stories. A large number of pedestrians killed in a two-week span? It must be “a worrying trend” caused by fast drivers and wide streets. Except that drivers aren’t going any faster than they were three weeks ago, and the roads aren’t any wider. Overall, the number of deaths on Toronto roads has been trending down for years. Why is it so hard to accept that the current spate of pedestrian casualties is simply a random statistical event?

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