Two Strategies for Limiting Investing Mistakes
Thursday, February 28, 2013
Charles Rotblut, CFA
AAII Journal Editor

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 28.4%, down 13.4 points
  Neutral: 35.0%, up 9.3 points
  Bearish: 36.6%, up 4.1 points

Long-term averages:
  Bullish: 39.0%
  Neutral: 30.5%
  Bearish: 30.5%

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Too often the focus of investing is picking the absolute best security for today, rather than avoiding the common mistakes that hurt portfolio returns year after year. Failing to have a system in place to avoid behavioral errors can adversely impact your returns. This is particularly important when it comes to hand-picking stocks and bonds because the ability to think differently and limit mistakes is what will lead to market-beating performance.

Accomplishing this can be very hard. Behavioral scientists have found humans to engage in herding. We tend to think and act like the majority of other people we observe, rather than being completely independent in our thoughts. Compounding matters is the fact that many of us are overconfident in our skills. It is not uncommon for investors, both individual and professional, to attribute poor performance to factors such as poor advice or bad market conditions, rather than their own decision process.

So, how do you avoid succumbing to the behavioral mistakes that affect the decisions of many investors? This was the question posed to five money managers at the recent RIA Investment Advisor Summit. Advisor Perspectives CEO Robert Huebscher, who moderated the panel, wrote a synopsis of the discussion on his company’s website. There were two suggestions that can be particularly useful for individual investors.

The first was a practice of seeking economic input from a variety of sources. Some of the panelists subscribed to several consulting services, including Ned Davis Research and Jim Grant. One panelist said he ignores the experts completely and relies on a combination of his internal staff and speaking to managers at major fund companies.

I prefer looking at the raw numbers and the trend instead of relying on someone else’s interpretation. I’ve included a link to an article listing the actual sources of the major economic reports below. I’ll also suggest Econoday, which does a good job of compiling and tracking the data for the major reports.

You should extend this outside thinking to security analysis. Take the time to read through the earnings release and analyze the financial statements. The annual 10-K filing required by the Securities and Exchange Commission (SEC) is also a good source of information. Research reports are great for identifying what you may have overlooked, but they should not be what you solely rely on to make your investment decision.

The second suggestion was having processes to identify and learn from mistakes. One panelist keeps a “mistake book.” As the name implies, this is a book that tracks investments that have not gone as planned. The rationale behind it is to identify what went wrong so the same mistake will not be repeated in the future.

Another panelist said his “single most valuable tool” was an “exception report.” This report tracks the performance of his managers on a monthly basis and flags them when the returns deviate too far from pre-established benchmarks. The idea is to identify anything that is out of the ordinary so it can be researched further.

I view the second suggestion as being invaluable. I use a spiral notebook to track my portfolio, writing down the reasons why I bought an investment, the reasons why I would sell an investment (which are determined before I buy it) and the reasons why I sold an investment. Increasingly, I’m combining this with a Google Docs spreadsheet for tracking company news on the stocks I own. I like the online spreadsheet because I can copy and paste snippets of news articles and press releases, while creating a time log of events that impact the company. The goal is to make the review process simple and to take my own emotions out of the decision process. Plus, if the stock ends up being a terrible choice, I can go back through my notes and see what I missed or mistakenly downplayed.

It is important to realize overcoming behavioral errors is not easy. However, if you are aware of what they are, you can build systems to cope with them—and that will help your investment returns.

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The Week Ahead

AAII’s Joe Lan will speak to our St. Louis Chapter this coming Tuesday, March 5. Joe will explain how to use stock screens to find a winning stock. Not in St. Louis? Check out our Local Chapters page to find a meeting near you.

Just five S&P 500 members are scheduled to report earnings next week as fourth-quarter earnings season comes to an end. Brown-Forman (BF.B), PetSmart (PETM) and Staples (SPLS) will report on Wednesday. H&R Block (HRB) and Kroger (KR) will report on Thursday.

The February ISM’s non-manufacturing index will be the week’s first economic report and is scheduled for release on Tuesday. Wednesday will feature the February ADP Employment Report, the Federal Reserve’s latest Beige Book and January factory orders. January international trade and revised fourth-quarter productivity data will be released on Thursday. Friday will feature February jobs data—including the unemployment rate and the change in nonfarm payrolls—as well as January wholesale trade data.

AAII Sentiment Survey

Individual investors have become cautious, as is evidenced by the largest weekly drop in optimism since November 2010.

Bullish sentiment, expectations that stock prices will rise over the next six months, plunged 13.4 percentage points to 28.4%. This was the largest one-week drop since November 18, 2010, when optimism fell from 57.6% to 40.0%. This is also the first time in eight weeks that bullish sentiment is below 40%. The historical average is 39%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, surged 9.3 percentage points to 35.0%. This is the highest neutral sentiment has been since August 16, 2012. The historical average is 30.5%.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose 4.1 percentage points to 36.6%. The rise puts pessimism at its highest level since November 22, 2012. The historical average is 30.5%.

The bull-bear spread, which measures the difference between bullish and bearish sentiment, turned negative for the first time since November 22, 2012. Prior to this week's reading, more AAII members were optimistic than pessimistic about the short-term direction of stock prices for 13 consecutive weeks.

Two concerns are weighing in on individual investors' moods right now. The first is the duration of the current rally. Many individual investors think the market has gotten ahead of itself and is due for a pullback in prices. The other is the looming threat of sequestration, which AAII members think could impact stock prices over the short term.

This week’s special question asked AAII members how the threat of sequestration is impacting their sentiment towards U.S. stocks. Slightly more than 40% of respondents said the threat was having little or no impact. Many think the publicity is worse than the actual fiscal standoff. Slightly more than a quarter of respondents described themselves as being more bearish or more worried about the short-term direction of stock prices because of the sequestration threat. Some members said they would view a pullback in stock prices as a buying opportunity and others said they were refraining from making purchases at this time. A few members think the current standoff could result in a solution that will be good for stocks over the long term.

Here is a sampling of the responses:

  • “There is a lot of media and pundit handwringing over sequestration. However, I think it will have a minimal impact on most investments.”
  • “Little impact. There may be a short-term effect, but in the long run, it may be a good thing as government spending has to be reigned in.”
  • “Not affecting my sentiment at this time, as I expect any bearish movement to be short term in nature.”
  • “It makes me very cautious.”
  • “It will hurt in the short run, but will have a positive effect three months out or more. This is because the market will react positively to the U.S. finally doing something about its debt crisis.”
  • “No impact. Our government is going to make good or bad choices. I can’t plan for it.”

» Take the sentiment survey