OUR EGOS CAN TORPEDO our investment decisions. Here are four examples, plus some suggestions for how to avoid these pitfalls:
1. Confirmation bias. People often support their strong financial opinions by only seeking out confirming information. One of my financial-planning clients worried about inflation and its potential impact on his savings. He only read articles that stated inflation and interest rates would soon be going through the roof. But this economic prediction didn’t come to pass. Instead, inflation and interest rates actually went down. Fortunately, he’d agreed to buy a diversified portfolio that didn’t depend on any particular economic forecast.
2. Overconfidence. Many of us like to think of ourselves as above average. The idea of simply matching the performance of the market with passive index mutual funds can seem mundane. Even if we know that index funds have outperformed more than 80% of active funds over 10-year holding periods, we may be convinced of our ability to pick a “market beater.”
Unfortunately, even active funds with a stellar history can come up short. Famed investor Bill Miller ran the actively managed Legg Mason Value mutual fund, which outperformed the S&P 500-stock index for an amazing 15 years in a row from 1991 to 2005. A Fortune magazine senior editor wrote an article in 2006 calling Miller “the greatest money manager of our time.” But in 2008, when the market crashed, his esteemed Legg Mason fund lost almost 18 percentage points more than the overall market. It ended up ranking in the bottom 1% of all U.S. stock funds for a five-year period.
3. Bruised egos. While we all make investment mistakes, our battered egos may not want to learn from a bad experience, let alone talk about it. Based on his accountant’s recommendation, my uncle bought into an expensive limited partnership. This partnership purchased a promising commercial site in Fort Lauderdale, Florida, near a proposed convention center. While the building location turned out to be thriving, the master partner proved to be dishonest and my uncle lost his entire investment. I suggested that he share his unfortunate experience with others, so they could learn from it. But my uncle felt his investment decision reflected badly on him, so he refused to discuss it.
4. Overvaluing complexity. When it comes to investing, there’s an advantage to admitting, “I don’t understand.” Enron and Bernie Madoff both had “magic formulas” that seemed to generate amazing returns. After they collapsed, it became apparent that even experienced investors didn’t understand them.
Today, expensive alternative funds offer complex ways to supposedly protect investment portfolios when the stock market tanks. But do they really help anyone, except their highly paid managers? Morningstar recently compared high-cost alternative funds with traditional low-cost bond funds. The Chicago research firm found that plain-vanilla intermediate-term U.S. Treasury bond funds provided the best protection during market downturns.
Struggling to remove your ego from your investment decisions? To get some fresh perspective, ask yourself: How would I advise someone who’s facing the same financial conundrum?
Rand Spero is president of Street Smart Financial, a fee-only financial planning firm in Lexington, Massachusetts. His previous articles were Human Factor, Why Wait and Help Yourself. Rand has taught personal finance and strategic planning at the Tufts University Osher Institute, Northeastern University’s Graduate School of Management and Massachusetts General Hospital.