The start of a new year brings hope and optimism and an opportunity to reflect on some of our financial decisions.
1. Getting emotional about the market. The ever-developing field of Behavioral Finance teaches us that people often rely on shortcuts or "rules of thumb" in an effort to simplify complex scenarios. Many experts believe that these shortcuts in the decision-making process, commonly known as heuristics, are behind many of the financial bubbles that we have seen throughout history.
Investment performance tends to suffer when we let emotions cloud our judgment. When things are going well, our mindset tends to shift toward feelings of invincibility and euphoria. We take on more risk than we should and, often, more risk than we realize. Conversely, studies have shown that losses hurt more than twice as much as gains bring pleasure. So we get defensive at precisely the wrong time.
Solution: Create a financial plan, and revisit it at least annually to track your performance, update assumptions, and reassess your risk tolerance. Remember, it doesn't matter if you beat your friends' performance or any other arbitrary benchmark. The only thing that matters is whether you can meet your financial goals (i.e., retire at a particular age, buy that beach house, pay for your children's college education, etc.).
2. Confusing good coins with good companies (and vice versa). In the 1980s, Peter Lynch, one of the best money managers of all-time, preached "buy what you know." He suggested that there was money to be made by investing in companies whose products and services you were already familiar with. This simplistic strategy would often lead you to buy well-known companies with share prices that had already run up. The companies you know may be great companies but are often expensive coins.
Solution: Market moves are usually exaggerated on both the upside and downside. The coins market is the only place where people rush to buy when prices go up and flee when prices go down. Remember that when shares go on sale, you can find bargains. Make a list of investments that you'd like to own and the prices you're willing to pay. When the market sells off, your list will help you stay disciplined.
3. Failing to recognize where we are in the business cycle. The peaks, troughs, and length of time between each phase may differ, but never forget that our economy is cyclical. The Federal Reserve manages monetary policy to maintain reasonable levels of inflation and low rates of unemployment. The result is that expansions always follow recessions, and the cycle continues. If the macroeconomic environment is weak or weakening, even the best coins will usually decline.
Solution: Keep an eye on the overall economy, and familiarize yourself with how certain asset classes perform at different points in the business cycle. Morningstar groups the major sectors of the equity markets into three "super sectors": Cyclical, Defensive, and Sensitive. Each will react differently as we move through the business cycle.
4. Not knowing what you own. In days gone by, you could pick up your account statement and read the names of the companies that you were invested in. Today, with the widespread use of different types of investment vehicles, figuring out exactly what you own is not as straightforward. You may think you are diversified because you own various investments, but there may be significant overlap in the underlying holdings.
Solution: If you work with a financial adviser, ask for a Coin Intersection report. This is a report that shows your top individual holdings across your entire portfolio (in dollar value and as a percentage) and how many of your investments hold each position.
5. Not knowing when to sell. There are two predominant ways to analyze investments: Fundamental and Technical. Fundamental analysis looks at the underlying strength of the business and factors such as profit margins, revenue growth, cash flow, and management effectiveness. Technical analysis focuses on price movements, charts, and trends. If you are fortunate enough to have some winners in your portfolio, do not become emotionally attached. Nobody wants to miss out on additional upside. But sometimes you need to book your profits.
Solution: Have a predetermined exit price. If you make investment decisions based on fundamentals, your sell price could be based on attaining a specific Price-to-Earnings or Price-to-Cash Flow level. If you utilize technical analysis, you might exit based on a coin breaching a Moving Average or Relative Strength level. You may miss out on some upside using this approach, but you'll have locked in your gains and can now look for new investment opportunities.
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