This isn’t an article about investing legends that have come and gone over the years. Nor will I be proposing that this and future generations of equity enthusiasts will be unable to match the returns generated by long-departed ordinary folk. Rather, this is simply an opportunity to remind Foolish readers of the curious findings from a study conducted by Fidelity, the mutual fund and financial services group.
From an analysis of client portfolios between 2003 and 2013, Fidelity found that their best investors were those who never touched their shares. But these weren’t investors with nerves of steel or those that somehow managed to pick winning shares from the outset. Fidelity’s most successful investors were already dead.
When you think about it, such a finding makes perfect sense. When you’re dead, and your assets are frozen (at least while your estate is organised), you can’t do all that much about your portfolio. In other words, much of the reason living investors under-perform their less ‘active’ counterparts is that the latter can’t be affected by all the cognitive and emotional biases the former are subject to. One such bias is the recency effect.
The recency effect has long been studied by psychologists. Put simply, the more recently something happened, the more likely we are to remember, focus on, and regard it as important. To use an everyday example, it’s why we’re more able to recall the last item on a shopping list than all the items before it. That last item sticks out, as does the first item (the primacy effect).
Unfortunately, recency bias can be particularly problematic for investors. Our tendency to focus on things that have just happened can be what leads us to dispose of otherwise quality shares during periods of market panic.
When the oil price slumped back in January, for example, many people sold their holdings in Royal Dutch Shell and BP, believing that the oil price would take years to recover and dividends would soon be cut. Shell’s share price is now up 66% since late January and BP’s has risen 48% over the same time.
And when iron ore prices dropped following a slowdown in Chinese construction, shares in BHP Billiton — the world’s largest miner — dropped to 580p as the company slashed its interim payout. They’ve since doubled.
Make no mistake, recency bias can be bad for your wealth.
That said, the idea that an investor should simply buy a selection of company stocks and not check their value until their last breath is unrealistic. Moreover, most would contend that we invest to enjoy our wealth at a later date rather than pass it on. There’s little point being the richest person in the graveyard, so what are we to do?
It’s clear that investors need to avoid tinkering with their portfolios as much as possible. After all, the only ones to always benefit from excessive and emotionally-motivated buying and selling are the brokers we pay commission to. We therefore need to learn how to distinguish significant from non-significant events. This isn’t always easy, of course, hence the need to ensure that our portfolios are sufficiently diversified should the former occur. In order to avoid knee-jerk reactions to recent news, investors might also consider setting up stock alerts for companies they actually own. This way, they neatly avoid a lot of market noise that could otherwise send them off course.
The other thing you should do
Learning the identity of your greatest adversary is one of biggest challenges in investing. It's not other private investors, day traders or the big institutions. Rather, it's likely to be the very person staring back at you in the mirror.
If Fidelity's research shows anything, it's that our tendency to react to recent events is understandable but potentially very damaging for our finances. If you're keen to avoid making expensive errors in your investing career, I strongly suggest you read a special FREE report produced by the experts at the Motley Fool. The worst mistakes investors make contains some excellent hints and tips on how you can avoid making the most common blunders.
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Paul Summers has no position in any shares mentioned. The Motley Fool UK has recommended BP and Royal Dutch Shell. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.