Our biggest stock market risk right now is the cockiness of the high-flying investor. Stocks have delivered fantastic returns this year, and over the past five years as a whole. Even laggards like utility and pipeline stocks have joined in the fun.
Enjoy this kind of market and the sense of satisfaction it gives you as an investor calling your own shots, but mind the risks. A recession is one example, but what I’m talking about here is more emotional than economic or financial. Strong markets make investors overconfident and vulnerable to mistakes that are revealed when stocks turn down, as they inevitably do from time to time.
For some thoughts on how investors can keep it real as stocks keep soaring, I reached out to finance professor Stephen Foerster of the Ivey Business School at Western University in London, Ont. Prof. Foerster has a new book out called Trailblazers, Heroes, and Crooks: Stories to Make You a Smarter Investor, and it has a lot to say about the risk of overconfidence. Here’s our exchange by e-mail:
Q: Stephen, can you tell us about your background as a finance professor and how you came to write your new book?
A: I’ve been a finance professor at the Ivey Business School for almost 38 years. My research has been in capital markets including stocks and bonds. My new book grew in part out of research for my previous book (with Andrew W. Lo), In Pursuit of the Perfect Portfolio: The Stories, Voices, and Key Insights of the Pioneers who Shaped the Way We Invest. I uncovered some fascinating investment stories, and we interviewed many trailblazers. I was on the lookout for fun, insightful stories with important investing lessons.
Q: You say in the book that investors don’t act rationally. Can you give us a few examples of irrational investor behaviour that you see happing now?
A: First, we often overreact, buying when stocks have gone up dramatically (think Tesla and Nvidia), and selling when they’ve gone down. But often that’s the wrong time. Hetty Green, who was the queen of value investing, was very successful at doing the opposite. And Warren Buffett knew when to be fearful when others were greedy, and greedy when others were fearful.
Second, sometimes we only hear and see what we want to. That’s how in 1720, a promoter from Cornhill convinced investors to invest in his company without revealing what the underlying business was – because it was just a scam. That’s also what happened in the 1990s with the infamous Canadian gold scandal, Bre-X.
Third, we have a bias to action when sometimes it better to do nothing. Knowing when not to act, such as avoiding panic selling when markets decline, is known as masterly inactivity. As Vanguard founder Jack Bogle once said, “When you hear news that moves the market and your broker calls up and says, ‘Do something,’ just tell him my rule is ‘Don’t do something, just stand there!’”
Q: We’ve had some excellent investment returns in the past five years across many different kinds of assets. How overconfident do you think investors are right now in assessing risk in their portfolios?
A: When we happen to have a string of great years in stocks or bonds, we often assume the trend will continue, uninterrupted. That’s when we often ignore risk and focus only on expected return. Overconfidence in our investing abilities is another irrational behaviour that leads to excessive trading and underperformance.
Q: Social media has changed the investing ecosystem dramatically by bringing us new ‘influencers,’ some of whom are selling their own systems for investing or, worse, trying to defraud people. What’s your take on how social media affects investing?
A: In the past few years, we’ve seen the impact of influencers who drove up the price of so-called meme stocks like GameStop. That led to FOMO, or fear of missing out. For most investors, when these meme stocks come back to earth, it doesn’t end well.
Q: The underlying theme of investment scams is an opportunity for bigger gains than people should expect from conventional investing. How do you rate the likelihood of finding a scheme on social media or online to actually get rich quick?
A: Slim to none. The one constant through investing history is scammers. Like Bernie Madoff, the biggest Ponzi Scheme fraudster, they know how to play on your emotions. Always remember: If something sounds too good to be true, it probably is!
Q: You’re speaking to a novice investor – what three pieces of practical advice can you offer to help them achieve long-term success?
A: First, develop an investment philosophy. That’s a set of informed investment beliefs and principles that guide your decision-making. For example, if you believe it’s really tough to beat the market, then you should buy and hold index funds.
Second, Save and invest! There are really only three levers to achieve our financial goals: How much we save and invest, how long we save and invest, and what returns we expect. To achieve a higher expected return, you need to take on more risk. And so, the more you save and invest, the less risk you need to take on.
Third, Diversify, diversify, diversify. Nobel laureate Harry Markowitz showed us that there is really only one free lunch when it comes to investing, and that’s diversification. It can help us to get a higher expected return for a given level of risk, or lower our risk for a given level of expected return.
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Rob’s personal finance reading list
The latest in kitchen reno trends
Colourful appliances are in. Not sure about the pink stove shown here, though.
A thorough review of apps that help you save on groceries, including some customer loyalty programs that provide cashback. Worth a look, even if you think you’ve already checked out all available grocery apps.
A look at how the 16 per cent wage gap between women and men affects housing affordability. On average, it takes almost three years longer for women to afford a down payment than men. There are city by city numbers here as well.
The writer of this first-hand account talks about how she used her creativity as an excuse to have a cluttered home. Then, she decided to clean out her basement and say goodbye to things she once thought she couldn’t part with.
Podcast fans
Subscribe to Stress Test on Apple podcasts or Spotify.
Ask Rob
Q: I’ve noticed that high interest savings account rates are dropping and I was wondering about your thoughts on the notice savings account. I’m wondering if the attractive rates will also be vulnerable to decreases as interest rates decline.
A: Here’s a column I wrote on the recent introduction of EQ Bank’s Notice Savings Account. Rates have already dropped for this account, but they remain very competitive. A good option for people who are in a position to give 10 or 30 days’ notice before making a savings account withdrawal.
Do you have a question for me? Send it my way. Sorry I can’t answer every one personally. Questions and answers are edited for length and clarity.
Tools and guides
Pros and cons of gifting money while living compared with at death.
In the social sphere
Social Media: A Reddit discussion on changes to the popular American Express Cobalt card, which take effect Oct. 8
Listen: Inflation is back to normal levels – why don’t we feel better about the cost of living?
Money-Free Zone: I’m really enjoying the new Kurt Vile cover of Tom Petty’s Sins of My Youth. Vile is one of the slacker kings of indie rock and his take on the Petty song is spot on thanks to the twangy guitars, falsetto vocals and what sounds like an out of tune saloon piano.
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