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Why do DIY investors often come up short?

From herd instinct to home bias, the psychology of DIY investors leaves many of them at risk of seriously underperforming the markets.

 

With access to easy-to-navigate investment platforms, managing our own share portfolios can appear simple – especially when markets are rising, but are we really winning when compared to letting an expert manage our investments? In this article we explore the psychology of DIY investors and how their behavioural biases can impact their decision making, often leading to them underperforming the markets and benchmarks of the professionals.

Over-confidence bias

Overconfidence bias is the tendency to see ourselves as more expert in our investing skill and knowledge than is the reality.  It's a common trait in DIY investing. A 2020 review published in the International Journal of Management found that overconfident individual investors generally do not manage and control risk properly.

One example of this would be a conviction that they can time the market even though markets are notoriously unpredictable.

Anchoring bias

When a professional firm looks at a stock, fund or alternative investment they recognise it requires multiple complex judgements around a wide set of criteria. This complexity makes many investment decisions vulnerable to anchoring bias. Anchoring bias is where someone values an initial piece of information too much to make sound subsequent judgments. For example, a person may hold on to a stock longer than they should because they've "anchored" on the higher price than they bought it at. The buying price biases their judgments about the stock's true value.

Herd mentality

Herd behaviour or the fear of missing out is one of the most common mistakes that DIY investors make. Following the advice of friends who recommend a stock, or even the “hot stock” tips promoted on internet forums will often lead to disappointment, typically by buying into a stock when it is already overvalued.

Share tipsters and friends might strike lucky once in a while – and they’ll be sure to promote their success, but you won’t hear about their less successful investment hunches. If you don’t spend the time to properly evaluate that investment based on all the available financial data then you risk blindly buying an investment based on hearsay. It can create massive bubbles like the Dutch tulip market bubble or the Dot-Com bubble, and the reality is bubbles burst.
 

 

Concentration bias

There are two reasons why investors can overly concentrate their portfolios. Firstly, many have a pre-disposition to choose stocks either that they are familiar with or in industry categories they feel they understand. Secondly, their bandwidth to research and manage a diverse portfolio is limited compared to the vast dedicated resources of a wealth management firm. Too much concentration equals higher risk because if one category suffers from market volatility then the value of that investor’s assets will be unduly impacted.   Diversification is crucial. By spreading your investments across different markets and asset classes you’re reducing your exposure to market turmoil in one particular sector.

Lack of an investment strategy

An investment plan should involve careful analysis, and proper consideration to put together a robust strategy for building a portfolio. It’s simply not something that you can put together in half-an-hour. And once you have a plan you need to stick to it. Too many investors are swayed by short-term movements in the value of their holdings. The temptation is to over-manage, switching investments and trying to chase losses rather than simply remaining patient. Selling at the wrong time can prove just as damaging over the long term. News headlines may create big ripples in the stock markets, but investment professionals know that when the emotional impulse is to sell, often the best financial decision is to do nothing and wait for markets to recover the lost ground rather than sell. One of the golden rules of investing is that investing is all about time in the market rather than timing it.

One of the benefits of letting professionals manage your money for you is that they will act in accordance with your pre-agreed personal investment goals and your long-term financial objectives. It means that once you have a long-term plan in place, they will make sure you stick to it, without getting distracted by short-term considerations. As investment guru Warren Buffet once noted: “Outstanding long-term results are produced primarily by avoiding dumb decisions, rather than by making brilliant ones”.

Loss aversion

For many people, investing can be an emotionally complicated subject. A person’s relationship with money usually begins at a very early age, and emotional responses can often overpower rational thinking when things are not going well. Studies have shown it is more painful to lose money than it is pleasurable to win it – even when the amount is the same. Many investors find this behaviour hard to come to terms with.

Taking a personally detached view from your investments is a good way to start making better investment decisions overall. But investing without emotion is easier said than done, especially when markets are falling. Therefore, understanding your own attitude towards money, as well as your personal risk tolerance, is an important first step. Working with an investment manager that makes the decisions for you can be helpful, as they put market falls into perspective while making sure your portfolio is best positioned to take advantage of the volatility.

DIY investing is not the same as financial planning

People often confuse investing with financial planning, but the two are very different. The benefit of good financial planning is that you have peace of mind from entrusting dedicated teams of people with professional qualifications, investment experience, a proven track record and the regulatory approval to carry out investment management duties on your behalf. They can take all of the emotion out of your investment decisions, and ensure common investment mistakes don’t occur.

Importantly, financial planning professionals will work with you to determine your life goals, your plans for your retirement, and the wealth you want to pass on to your children and grandchildren. Only then will they build a portfolio designed to achieve the outcome you want. They can also help to grow your wealth by providing access to a range of sophisticated alternative investments such as Private Equity and Venture Capital Trusts that are typically not available on transaction-only fund platforms.
 

Sand castles on a beach

Could a wealth manager make you wealthier?

This article explores why a professionally managed portfolio can really pay dividends.

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