Having covered on the Seven Sins of Fund Management previously, I would be covering on the Seven Sins of Investing. Investors have been constantly making the same mistakes that have landed them in trouble for decades. They are either enticed by the latest trending company, crowd mentality, overlooking important details, etc. In this series of Seven Sins of Investing, I would be devoting each subsequent post on each sin.
“When it comes to money, we are operating as if we were in the jungle, having to deal with predators like tigers,” says Brad Klontz, a clinical psychologist and associate professor of financial planning at Kansas State University. “We have a caveman brain.”
Seven Sins of Investing
Sin 1: Lust – Chasing of performance
The definition of lust is, ‘to have a yearning or desire, have a strong and excessive craving’. This is where investors believe that the recent performance of a stock will dictate future performance. This is otherwise known as ‘recency bias’ in behavioural psychology.
How often have we bought a stock thinking that the price will continue to grow? Perhaps when we first bought a stock, it was undervalued and as the price kept nearing fair value, we keep averaging up, thinking that we should invest more in the winning stock.
Perhaps something that we can all relate to. In the lead up to the Global Financial Crisis 2008, investors were all investing into the real estate market in the US, convinced that the rising housing prices would never falter. In the recent movie – The Big Short, one could see how even the best would make mistakes.
How do we combat lust? Always take a world view on equities and ask oneself if the valuation makes sense. Often, I hear investors reasoning that a company is cheap based on an industry earnings multiple. For example, Twitter trading at a P/E of 50x is cheap, given how the industry average P/E is 60x. While it is indeed true that Twitter is trading at a lower multiple compared to the industry, however, if we are comparing to stocks in the entire stock universe, is a P/E of 50x really cheap?
With a P/E of 50x, it is trading with an earnings yield of 2%. Compared to a risk free asset (30Y US Treasury Bond) that is probably trading at 3%, how could we reason that Twitter is cheap? One would expect a higher earnings yield for holding a more risky asset.
In the next article, I would be covering on Sin 2: Pride, where we get overconfident with our own success.