Your Worst Enemy? Yourself, if You’ve Got These Bad Habits

Matt Matros thought he was a pretty good investor--until recently.

This year’s slump in technology shares has whittled his $38,000 stock portfolio by $5,000 and shaken his confidence to boot. The 21-year-old student at USC realized he had developed some bad investing habits, such as buying stocks purely on impulse.

Take, for example, his purchases of Lucent Technologies Inc. and Agilent Technologies Inc. shares in early July after the stocks’ prices tumbled.

“I purchased huge chunks of each at ‘bargain’ prices without properly researching why their prices went down so low,” Matros said. “Both companies fell even further, and I decided to just cut my losses.”

Overestimating one’s investment skill and investing without a long-term plan are two of the worst habits an investor can have, financial planners say. Yet only recently have many investors had to face the idea that their own bad behavior could be hampering their returns.

That’s because five years of steadily rising stock pricesthrough 1999, masked the effects of sloppy investment practices, experts say. A generally rising market may reward investors who buy stocks based on rumors, for example, or who chase last year’s hot mutual funds without any thought about whether they fit an investment plan.

A more volatile market--such as the one investors are experiencing this year--can brutally punish those same behaviors.

Many investors “have confused the luck of riding the wave--being at the right place at the right time--with the skill of surfing the wave,” said Eric Bruck, a fee-only financial planner in Culver City. “They have had to learn the hard way the lessons of humility and sobriety when it comes to this market.”

In other words, to make money in today’s market, many investors may need to change their evil ways. And they should start with the bad habit that’s a direct result of the long-running bull market: overconfidence.

Just as most people rate themselves above-average drivers, many investors overrate their skill at picking investments. A 1997 survey of American Assn. of Individual Investors members found a sample group overestimated their own performance and their ability to beat the market. The investors believed their returns were an average 3.4 percentage points higher than they actually were.

When asked to estimate how well they did relative to market benchmarks, such as the S&P; 500, the investors guessed they earned an average 5.11 percentage points better than they actually did.

Bruck believes that few individual investors have a clear notion of their true returns. Instead, many play up their winning investments in their minds, while glossing over their losers.

The conviction that they can beat the market leads many investors to trade too much, which also hurts their performance, contends Terrance Odean, a finance professor at UC Davis who studied trading patterns of discount-brokerage customers.

Odean found that the most active traders between 1991 and 1996 had average annual portfolio returns of 11.4%, compared with 17.9% for the Standard & Poor’s 500 index. Investors who traded infrequently had returns averaging 18.5%.

Beardstown Ladies Syndrome

Why would investors persist in such self-destructive behavior? Some may suffer from the Beardstown Ladies syndrome, named after an Illinois investment club that wrote a book about beating the market--then discovered that they had massively overstated their returns because of a simple math error: The club failed to exclude the effect of its own regular cash contributions to the portfolio when calculating returns.

In the same way, investors who see steadily rising balances in their 401(k) accounts may believe they’re doing quite well, when in fact much of their gain may be coming straight from their paycheck contributions and their company’s matching contribution.

Meier Statman, a finance professor at University of Santa Clara and an expert on investor behavior, believes that if more investors took a cold, hard look at their actual returns, most would give up active trading and opt instead for passive, buy-and-hold investments in mutual funds that mimic indexes of blue-chip stocks, smaller stocks and other broad sectors over time.

Another bad investor habit is investing without a long-term plan. If investors don’t know why they’re investing, they won’t know how much risk they can safely take or how best to divide up a portfolio among various investments, financial advisors say.

Matros admits that setting goals has not been his strong point. He started investing at age 14, buying computer maker Gateway and athletic shoe giant Nike. In the intervening years, he simply kept buying and selling stocks, without trying to figure out his short-term or long-term plans for the money.

Now that his net worth no longer climbs with each trade, he is starting to worry about whether he is properly diversified and whether he should be investing some of his money in lower-risk investments as a safety precaution.

Financial planners typically say that people must set goals and determine the time frames for achieving those goals before they can decide how to properly structure an investment portfolio.

Someone investing for a distant retirement, for example, can and should be taking more risk than someone saving for a home purchase next year. That’s why planners recommend heavy weightings in stocks and stock mutual funds for retirement savings accounts, while money for a down payment on a home is almost always kept in safer, more liquid money market accounts.

By the same token, most investors who take big risks--such as actively trading volatile technology shares--should be investing primarily with “play money” that they can afford to lose, experts say.

Many people have learned that lesson the hard way this year.

Chasing What’s Hot

Financial planner Ross Levin, like many advisors, first works with clients to set goals, then sets up portfolios with a diversified mix of investments geared to meet those goals. If the client still wants to try his hand at trading individual stocks, Levin sets up an account with money that isn’t needed to meet other goals.

Some of the play-money accounts have done well, said Levin, whose Minneapolis-area firm Accredited Investors Inc. specializes in wealthy clients.

More typically, Levin’s clients have suffered losses, especially in recent months as the market has declined, he said.

“We set up a $100,000 fun account for a Microsoft employee who realized how ‘unfun’ it was when it turned into $50,000,” said Levin, who added that the client has since turned over the money to Levin’s firm to invest. “It’s only fun when it’s going up.”

For many investors, a bigger problem is the habit of chasing whichever investment was hot last quarter or last year.

In 1998 and 1999, buying stocks that were already climbing, without knowing anything about the company behind the shares, was a strategy that often worked--especially with technology stocks. People made money as other investors hopped on the bandwagon and the stocks continued to rise, often in spite of themselves.

That also fostered more of what might be called “rearview-mirror” investing--buying a mutual fund because the manager’s investment style did well in the recent past, or sticking with an investment strategy whose time has passed.

It’s true that every market trend has to start somewhere, and once underway, a trend can last for some time.

But the longer it goes on, such “momentum” investing tends to carry individual stocks and stock sectors to absurd heights. When the momentum finally exhausts itself, the downside can be horrendous.

Matros learned that when he bought Agilent and Lucent as they were falling this summer. He figured the stocks would quickly regain their upward momentum, giving him a quick profit. He admits he paid no attention to the businesses or the stocks’ price levels relative to expected earnings.

As other investors continued to bail out, Matros’ fast-profit expectations were foiled.

Heavy losses in investments gone awry often bring out another bad habit in many people: hanging on too long to losers.

No financial advisor would argue against buy-and-hold investing for your core portfolio. Bear markets come and go and shouldn’t trouble long-term investors.

But when it comes time to sell something or make a portfolio shift for whatever reason, many people choose to sell their winners while holding on to their losers. In part, that’s because selling a loser means having to admit you made a mistake, UC Davis’ Odean said.

“It’s an attempt to minimize regret,” he said. “If you don’t sell, you don’t have to lock in that regret. You can continue to think that [the stock price] might still come back someday.”

And indeed, stocks often do rebound--if you can wait long enough. But it’s also true that for some depressed investments, a better tomorrow never arrives.

Taking your losses and moving on can be very smart from a tax standpoint, if the investment is in a taxable account: Capital losses can be used to offset capital gains for tax purposes.

Odean’s studies have shown that investors who cling to losers tend to hurt themselves. He found that the winning investments people sold did better by an average of 3 percentage points between 1991 and 1996 than the losing investments they hung onto.

“They didn’t have to deal with regret,” Odean said, “but they didn’t get the returns they could have.”

*

Times staff writer Liz Pulliam Weston can be reached at liz.pulliam@latimes.com