Behavioural Traps (1)

Behavioural Traps (1)

(The investing story of Dave and Jennifer)

Psychological factors can thwart rational analysis and prevent investors from achieving the best results for their portfolio. Let's explore these behavioural traps through Dave, his wife Jennifer and his investment counselor IC.

The Technology Boom, 1999 -2001

TIME: October 1999

Dave: Jen, I've made some important investment decisions. Our portfolio contains nothing but these old fogy stocks like Philip Morris, Procter & Gamble, and Exxon. These stocks just aren't doing anything right now. My friends Bob and Paul at work have been making a fortune in Internet stocks. I talked with my broker, Allan, about the prospects of these stocks. He said the experts think it is the wave of the future. I'm selling a lot of my stocks and I am getting into the Internet stocks like Amazon, Yahoo!, Inktomi, and others.

Jennifer: I've heard that those stocks are very speculative. Are you sure you know what you're doing?

Dave: They had their time, but we should be investing for the future. I know these Internet stocks are volatile, and I'll watch them carefully so we won't lose money. Trust me. I think we're finally on the right track.


TIME: March 2000

Dave: We are up 60% since October. The Nasdaq crossed 5,000 and no one I heard believes it will stop there. The excitement about the market is spreading and it has become the topic of conversation around the office.

Jen: You seem to be trading in and out of stocks a lot more than you did before. I can't follow what we own!

Dave: Information is hitting the market faster and faster. I have to continuously adjust our portfolio. Commissions are so cheap now that it pays to trade on any news affecting stocks. Trust me. We are up 60% in the last 6 months.

TIME: July 2000

Jen: Dave, look at our broker's statement. We don't hold those Internet stocks any more. Now we own Cisco, EMC, Oracle, Sun Microsystems, Nortel Networks, and JDS Uniphase. I don't know what any of these companies do. Do you?

Dave: When the Internet stocks crashed in April, I sold right before we lost all our gains. Unfortunately, we didn't make much on those stocks, but we didn't lose either.

I think we're on the right track now. Those Internet companies weren't making any money. All the new firms we now own form the backbone of the Internet and all are profitable. Most of the Internet companies are going to fall, but those supplying the backbone of the Internet - the routers, software, and fiber-optic cables - will be big winners.

Jen: But I think I heard some economist say that they are way overpriced now; they're selling for hundreds of times earnings.

Dave: Yes, but look at their growth over the last 5 years - no one has ever seen this before. The economy is changing, and many of the traditional yardsticks of valuation don't apply. Trust me; I'll monitor these stocks. I got us out of those Internet stocks in time, didn't I? Don't worry.


TIME: November 2000

Dave (to himself): What should I do? The last few months have been dreadful. I'm down about 20%. Just over 2 months ago, Nortel was over 80. Now it is around 40. Sun Microsystems was 65, and now it is around 40. These prices are so cheap. I think I'll use some of my remaining cash to buy more at these lower prices. Then my stocks don't have to go up as much for me to get even.


TIME: August 2001

Jen: Dave. I've just looked at our broker's statement. We've been devastated! Almost three-quarters of our retirement money is gone. I thought you were going to monitor our investments closely. Our portfolio shows nothing but huge losses.

Dave: I know; I feel terrible. All the experts said these stocks would rebound, but they kept going down.

Jen: This has happened before. I don't understand why you do so badly. For years you watch the market closely, study all these financial reports, and seem to be very well informed, yet you seem to always make the wrong decisions. You buy near the highs and sell near the lows. You hold on to losers while selling your winners. You...

Dave: I know, I know. My stock investments always go wrong. I think I'm giving up on stocks and sticking with bonds.

Jen: Listen, Dave. I have talked to a few other people about your investing troubles, and I want you to go see an investment counselor. They use behavioural psychology to help troubled investors understand why they do poorly. The invstment counselor even suggests ways to correct this behaviour. Dave, I made you an appointment already. Please go see her.


Related:
Behavioural Traps (1)
Behavioural Traps (2)
Behavioural Traps (3)

Ref: Stock for the Long Run by Jeremy J. Siegel 3rd Edition Pages 316-327