Here is something interesting... If we headlined this article, "Knowing your investor personality can make you money," it would appeal to different people than if we called it, "Knowing your investor personality can avoid losses."
Some folks are risk-averse and more highly motivated to avoid losses than seek gains. Their behaviour and decisions are more often influenced by fear.
Some investors are the opposite, where greed is more often the dominant motivator.
Knowing your own investor personality can therefore be critically important. But here's the kicker, and the real reason you need to know about these things:
Regardless of attitude or tendencies, many people base their perceptions about potential risk and reward on what has happened in the immediate past rather than in a more reasonable time period. This will cause them to make faulty choices that move them away from their goals rather than toward them.
This is called the recency effect and is one of a number of fascinating and important concepts identified and explored in the study of investor behaviour. Recency identifies the strong tendency for investors to look at what has just happened and extrapolate that into the future. For example, in October 2007, the markets had been rising strongly for several years, with the Toronto index doubling.
Rather than be cautious that this overstretched bull market might come to an end, the vast majority of investors began to throw caution to the wind and accepted the higher levels of risk inherent in paying such high prices.
On the other hand, in March 2009, after a 50 per cent drop in prices, many investors avoided any form of risk, assuming the recent past would be repeated.
These phenomena applied to many professional money managers as well as people managing their own money. Being a contrarian and going against the herd can therefore provide an opportunity for higher returns with less risk. When the market is risk-on, a wise investor is smart to make money from the resulting rise in prices, but cautious enough to avoid the greed factor as prices get too high.
Modern investment science and respected theories such as the capital-asset pricing model and the efficient-frontier are based on three premises. These are that people as a whole are rational and self-interested, and all information about companies and markets is usually available to all market participants at the same time.
This is the efficient market theory, which at its simplest says all factors influencing a stock's price are already built into the price.
To some extent, these things are true. If an investor believes them to be almost completely true, then that person would choose to be a passive investor, using index funds and ETFs rather than active management.
If, instead, an investor believes mass psychology and other factors can result in stock-pricing anomalies, then that person may favour active management. These proponents believe there are factors not known to the market as a whole, if one looks carefully for them, and these factors can be exploited for profit.
My own belief is the combination of investor-psychology factors and investment-selection skill can add value to money management, especially in some markets. However, many active managers are too often the victim of the same psychological factors, and too many lack enough skills to add such value. As a result, we use a mixture of the two styles.
For you, start by dissecting how you make decisions and why you make them. That process alone may help you make better choices.
David Christianson, BA, CFP, R.F.P., TEP, is a financial planner and adviser with Christianson Wealth Advisors, a vice-president with National Bank Financial Wealth Management, and author of the book Managing the Bull, A No-Nonsense Guide to Personal Finance.