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In my dealing with investment clients, I often find my clients falling in love with their investments. I will always counsel them to distance themselves from their investments because once they become too emotional, their investment decision making becomes subjective. How do you know you are in love with your investments?
First, if you have been investing based on the past success of the investment, you could be falling in love with it. The word to describe it is ‘representativeness’. Examples of representativeness are “I am investing more because this fund has provided 20% return in the past year” or “I am investing more in REITs because it has provided me with good dividends”. The correct approach in investment is forward looking. There is no reason history will repeat itself. Investments should be based on current valuation and growth prospects. Just because things have been good in the past does not mean it will be in the future.
Second, a concentrated portfolio is another symptom in falling in love with your investments. I recall I had a case in which the client had a couple of million dollars in just a few stocks. When I asked him the reason I was told he invested huge amount of money in those stocks during the financial crisis strongly believing he would reap a large profit later. The word to describe such behavior is called ‘Overconfidence’. Overconfidence can lead to excessive trading and concentrated (undiversified) portfolios. Concentrated portfolios can lead to massive losses.
Third, a portfolio consists mainly of REITs, preference shares or real estate could be a symptom of falling in love with investments. This is known as ‘Self-control’. Such an individual has a desire to have control over the investments and wealth. For them, cash flows are considered income rather than part of the portfolio return. For example, many retirees prefer high dividend-paying stocks and bonds because they feel they are spending the cash flows from their portfolios only and not the principal. However, the right approach is total return rather the treating dividends and principal as separate. In today’s technology, it is possible to create a stream of cash flows automatically even in portfolios that have no dividend.
Fourth symptom. Does your portfolio consist mainly in Singapore stocks? You may have fallen in love. Specifically, you could be suffering from familiarity bias or home bias. Familiarity bias means the tendency to avoid ambiguity and invest in securities with which you are familiar with. Home bias means the tendency to invest in domestic securities over international securities due to familiarity with the local market. Familiarity bias and home bias tends to produce poorly diversified portfolios, ignoring many other investment opportunities in many part of the world. For those who are working in Singapore, it may not be advisable to invest in Singapore stocks as both your employment and investments could go down together during economic crisis.
The fifth symptom. Have you ever face with a situation in which you are reluctant to cut lost? I face the same situation with my clients when they refuse to sell existing funds. Usually the main reason is not wanting to cut lost. Effectively they have ‘fallen in love’ with the fund except that it is a painful love-hate relationship! We call such problem as ‘loss aversion’. Loss aversion means the reluctance to accept losses. Usually this problem arises due to the misconception of realized and unrealized losses. They feel that as long as they do not sell, these losses are merely on paper. In many developed countries, there is a material difference between realized and unrealized losses due to tax-loss harvesting. In Singapore, there is no difference in tax treatment between realized and unrealized. Moreover, for liquid assets such as unit trusts, realized and unrealized losses are identical in monetary value. Therefore, it is a fallacy to say losses are only ‘on paper’ if the investment isn’t sold. Loss aversion is a serious problem because it can lead to risk seeking behavior due to the insistency in remaining invested in an investment that has increasing higher risk. The right type of behavior is risk minimization and return maximization.
To me, loss aversion is the most common and worst time type of problem. I have seen it in clients who speculated in dual currency on the advice of the bank only to be ‘converted’ to a foreign currency at a loss. Their refusal to convert back to local currency in order to cut losses and eliminate further risks taking often results in massive currency losses.
My advice to everyone is you need to be aware of the psychology behind investments. Sometimes the greatest enemy is your own self. Never fall in love with your investments. When in doubt, consult a professional investment adviser.
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