7 Deadly Sins of Investing

Editor’s note: This story originally was published in the March 1998 issue of Kiplinger’s Personal Finance magazine.

If you want to irk a financial planner, try this: Don’t take money out of your fat savings account to pay off credit card bills. It drives planners nuts. Of course, you’re making only 4% on your bank account and paying perhaps 18% on your credit cards. So paying off those credit cards is like earning an instant 18% on your money.

Wasting that kind of money is, well, a sin. But planners report that not taking that simple step is a common problem with clients, and one that’s not easy to fix. "You can run charts, show the numbers, spin around in your chair and stand on your head," says New York City financial planner Gary Schatsky. "But some people won’t budge."

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No doubt about it: We have all sinned and fallen short of financial perfection. And, as Schatsky points out, rationality often isn’t enough to make us break bad investment habits. What may help is understanding some solid (though subliminal) psychological and emotional reasons we perpetuate the credit card paradox and other seemingly irrational -- even ridiculous -- ways we handle money.

For example, consider the following scenarios that help explain the credit card conundrum: You travel to the theater with a $40 ticket in your pocket. At the box office, you discover the ticket is missing and that to buy a new one will cost another $40. Do you do it?

Or this: You were planning to buy a ticket once you got to the theater, but when you open your wallet at the box office, you discover you are missing $40. Do you still buy the ticket? If you decide to see the play, the result is the same in either case -- at the end of the evening your wealth will have been reduced by $80. But while almost 90% of people say they would buy a ticket after having lost $40, fewer than half as many would replace a lost ticket by spending another $40.

The reason for the discrepancy is that we separate money into "mental accounts," according to the late Amos Tversky, one of the fathers of "behavioral finance," which studies how our quirks and predilections affect our investing. So in the case of the lost ticket, the $40 it cost represented a debit to the "theater account," and an extra $40 for a new ticket would have meant spending $80 in total on the play. However, losing $40 cash is for most of us a debit from another mental account, so the cost of the play would still be just $40. In the same way, we may separate our "credit card" from our "savings" mental accounts.

Hoarding money in a savings account can be a deadly financial sin, akin to gluttony, because it represents an unrestrained desire for an asset that isn’t being put to its best use. For Schatsky, the first step toward repentance is to acknowledge that your hoarding is actually costing you money. "Only when someone will say to me, ’I know that costs me $1,000 a year,’ will I rest," he says.

Gluttony is but one of the Seven Deadly Sins passed down to us from the Catholic Church of the Middle Ages. We’ve also found financial parallels to the other six. Avoid all of them and you just might be able to keep your portfolio out of purgatory.

Greed

As this sentence is being written, some colleagues sit at the corner Starbucks checking $130 worth of lottery tickets bought in a pool in the hope of hitting a $48-million pot. Now if anyone should know better, it’s a pack of personal-finance journalists. But sometimes the lure of a big score just cannot be resisted.

The reason is that it’s human nature to overweight low probabilities that offer high returns. In one study, subjects were given a choice between a 1-in-1,000 chance to win $5,000 or a sure thing to win $5; or a 1-in-1,000 chance of losing $5,000 versus a sure loss of $5. In the first case, the expected value (mathematically speaking) is making $5. In the second case, it’s losing $5. Yet in the first situation, which mimics a lottery, more than 70% of people asked chose to go for the $5,000. In the second situation, more than 80% would take the $5 hit.

If like many people you can resist anything but temptation, the answer may be to limit your "mad money" by setting up a small, separate account for such things as trading speculative stocks. To limit completely irrational risks, such as lottery tickets, try speculating only with money you would otherwise use for simple pleasures, such as your morning coffee. If you buy it at Starbucks, that can add up to a hefty sum -- but you won’t bounce the mortgage check.

Pride

In hindsight, it’s easy to see that no matter how lovingly you waxed your first car or upholstered the dashboard, it was, in fact, a heap. Yet at the time you truly cherished that pile of corrosion. In the same way, we tend to let pride of ownership inflate the value of our investments.

For example, researchers gave a group of volunteers a coffee mug and asked them to write down their lowest selling price for it. Other volunteers were asked to write down the highest price they’d pay for the mug. Because both groups were chosen at random, you’d expect some commerce. But very little took place because sellers priced the mugs at $5.75 on average, and buyers at $2.25.

In investing, this so-called endowment effect leads us to value our own investments more highly than the market does. Some who fall prey to it hold on to securities too long and don’t sell when the market is telling them to bail or to seek new and better opportunities. One solution is to set limits when you first purchase a security -- such as a stop-loss order, which will sell a security automatically when its price falls to a certain level.

Dovetailing with this pride of ownership is the tendency to fall in love with companies you may feel particularly proud of or are familiar with. A study done by Gur Huberman, a finance professor at Columbia University, looked at investment patterns of the regional Bell holding companies, commonly called the Baby Bells. In all but one state, his study found, people tend to hold many more shares of the closest Baby Bell than any of the others -- an average of $14,400 worth of the local, versus $8,200 for the others.

Every parent thinks his or her baby is the prettiest, but not all of them are correct. Likewise, not every Baby Bell investor who believes his or her stock to be the best can be correct.

Huberman says that while Baby Bells nicely make the point, a more depressing example is lopsided 401(k) portfolios. According to the Profit Sharing/401(k) Council of America, the average investor’s defined-contribution plan has about 24% of its assets in company stock; for employees of the largest public companies, the amount is about 40%. Huberman says that while the risk "may not be huge" in choosing to invest in one phone company versus another, concentrating so much of your net worth in one stock is unwise.

We’re not suggesting that the hundreds of Microsoft and Intel employees who became millionaires by owning an inordinate number of shares of their companies were stupid. But if you feel your company is rocketing along a similar trajectory, just remember that fate is fickle when dealing with pride. Could you get by -- could you achieve your goals -- if the stock you own in overabundance were to lose three-fourths of its value?

Penance, in this case, is doing a thorough job of comparing companies close to home with their peers in other parts of the country. And in the case of your 401(k) account, unless you have strong, logical reasons for holding a large percentage in your company’s stock, don’t let it dominate your assets.

Lust

Temptation leers at us from so many sources today: the Internet, new TV channels, new magazines, to name a few. We’re not talking about smut, but financial information. "I think we’re bombarded with news," says Needham, Mass., financial planner Constance Barber, a former psychologist who thinks this overload of stock prices, economic reports and flashy business programs gives investors itchy trigger fingers when buying and selling investments.

Compounding this overload is a tendency by many investors to lust after even more tidbits of undigested information. Thus, they jump into or out of a stock when the latest blip doesn’t have anything to do with the long-term health of the company. Terrance Odean -- an assistant professor of finance at the Graduate School of Management at the University of California at Davis who has studied the trading patterns of individual investors -- suggests two strategies to combat snap decisions: One is buy and hold, while remembering the reasons you bought. The other is, "Don’t open the paper." Personally, Odean says, he hasn’t checked the price of a stock mutual fund he has in an IRA in about a year.

That may be extreme, but weaning yourself from reacting to too much news may save not only time, but dollars and angst as well.

Envy

The tendency to want what other investors have can lead you to chase stocks or mutual funds with the biggest recent returns, but that can be a losing strategy.

Consider Lexington Troika Dialog fund, up an impressive 68% in 1997. Yet many of its investors actually sent their portfolios to the gulag by chasing the fund’s returns, which at one point in 1997 were around 130%. Those investing at the top -- before Russia caught a case of the Asian flu -- lost almost 50% of their investment. Considering that the fund started late in 1996 and by mid 1997 had assets of more than $200 million, a legion of investors apparently succumbed to its charms.

In the case of stocks, a study by three finance professors found that "glamour" stocks, those with the most robust sales growth and highest ratio of price to cash flow during the previous five years, were miserable performers during the subsequent five years, compared with stocks at the opposite extreme. So to buy stocks with the highest past rates of growth and hold them indefinitely may be perilous to your wealth. You’d be better off buying and holding stocks whose past earnings growth was least impressive. The psychological phenomenon here is called "representativeness," or the tendency for us to believe even short-term trends will continue into the future.

Overcoming the follow-the-leader mentality is particularly tough because the stocks that brokers promote tend to be the glamour issues, says University of Illinois finance professor Josef Lakonishok, an author of the study. What’s worse, even analysts who should know better tend to "extrapolate past performance way too far," he says.

If you’re blinded by glamour, you might consider tempering your portfolio with a dose of unadulterated value. For good choices in value funds, see the Kiplinger 25, our favorite no-load mutual funds.

Anger

For investors, anger takes a couple of forms, the most damaging of which may be anger with yourself for making poor investment decisions. In psych terms, this is called "aversion to regret" and comes from our irrational tendency to beat ourselves up for making bad decisions.

Say you began last year invested in the tried-and-true Fidelity Magellan fund. You’d heard Russia was where the investment action was going to be, so you thought about switching your Magellan money to Lexington Troika Dialog, then decided to pass. Your friend, on the other hand, began the year in the Russia fund, but figured President Yeltsin’s health was too iffy and played it safe by switching to Magellan.

In 1997 you both would have earned Magellan’s respectable 27% and lost out on the Lexington fund’s 68%, but your friend would be kicking himself more than you because we regret taking action more than inaction. This often leads to poor investment choices, especially not selling a losing investment. That’s because to sell is to admit to a loss -- and feel regret.

If aversion to regret has you frozen, focus on your portfolio’s goals, not on individual investments or what returns others may be earning.

Sloth

Perhaps the most amazing thing about the Steadman Technology & Growth fund isn’t its truly appalling performance -- an average annualized loss of 27% over the past five years. The most amazing thing is that $300,000 is still invested in the fund, which points to one of the great mysteries in the mutual fund industry: how consistently bad funds manage to keep any investors at all.

Researchers have come up with a number of reasons for such investor inertia -- read sloth -- ranging from irrational behavior to fear of high transaction costs. But a recent study has shown that mutual fund investors may keep their money in laggards because they can’t come to grips with how poorly these funds are performing. A survey of presumably well-informed investors -- members of the American Association of Individual Investors -- showed that they overestimated the annual total returns of laggard mutual funds by an average of 3.4 percentage points.

The reason, speculates the author of the study, Professor William Goetzmann of Yale University, is something you may remember from your Psych 101 class: cognitive dissonance. Basically, this means we change our beliefs to support past decisions. So in the same way nobody admits the car they bought turned into a financial sinkhole, some people can’t come to grips with the fact that the fund they own is a dog, so the dog is never put to sleep.

Another reason for inertia is the emotional attachment we may form with a particular stock. Financial planner and psychologist Maury Elvekrog, based in a Detroit suburb, often finds himself in the sticky situation of parting a client from inherited General Motors shares. "They do take it personally," says Elvekrog.

His advice is a worthy exercise in contrition for all financial sins: "Always look at investments as if you were looking at them from scratch. It’s not whether you like something. It’s a matter of intellectual evaluation."