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5 ways to be a smarter investor

Morningstar  |  17 Nov 2015Text size  Decrease  Increase  |  

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This is an edited extract from an article which initially appeared on Morningstar's US website.

 

Warren Buffett states that: "Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ." Instead, what gets people into trouble is their temperament and making the wrong decisions.

Yet, once you are aware of it, you can actually control these biases which in turn can have a pretty big impact on your returns.

 

Sunk costs

The sunk cost fallacy theory states that we are unable to ignore the "sunk costs" of a decision, even when those costs are unlikely to be recovered.

One example of this would be if we purchased expensive theatre tickets only to learn prior to attending the performance that the play was terrible. Since we paid for the tickets, we would be far more likely to attend the play than we would if those same tickets had been given to us by a friend.

Rational behaviour would suggest that regardless of whether or not we purchased the tickets, if we heard the play was terrible, we would choose to go or not go based on our interest.

Our inability to ignore the sunk costs of poor investments causes us to fail to evaluate a situation such as this on its own merits. Sunk costs may also prompt us to hold on to a stock even as the underlying business falters, rather than cutting our losses. Had the dropping stock been a gift, perhaps we wouldn't hang on quite so long.

 

Anchoring

Ask New Yorkers to estimate the population of Chicago, and they'll anchor on the number they know--the population of the Big Apple--and adjust down, but not enough. When estimating the unknown, we cling to what we know.

Investors often fall prey to anchoring. They get anchored on their own estimates of a company's earnings, or on last year's earnings. For investors, anchoring behaviour manifests itself in placing undue emphasis on recent performance since this may be what instigated the investment decision in the first place.

When an investment is lagging, we may hold on to it because we cling to the price we paid for it, or its strong performance just before its decline, in an effort to "break even" or get back to what we paid for it.