Successful investing isn't about beating the market or chasing the biggest gains. And if you steer clear of the most common mistakes, you've already won half the battle. Martin Weber, Senior Professor of Finance at the University of Mannheim, discusses investor psychology, risk profiles and what separates good investment strategies from bad ones.
According to finance professor Martin Weber, most investors trade too much - and hurt their returns.
Trying to beat the market often backfires, says the behavioural finance expert.
Diversification is key to a solid strategy, Weber explains.
Thinking long term and avoiding emotional traps is what works, he says.
When you invest, you make assumptions about the future. The problem is that it's impossible to know which direction financial markets will go in: no one can predict whether a particular security's share price will rise or fall. Many people find it hard to deal with that uncertainty.
The biggest one is overtrading. Constantly buying and selling securities tends to hamper returns for two reasons. First, every transaction involves fees and taxes. Second, most investors buy and sell at the wrong time - and end up losing money.
When it comes to money, people fall prey to many psychological and emotional traps - above all, overconfidence. Ask drivers how good they are, and most people will tell you they're better-than-average drivers - though that's statistically impossible. A similar bias appears among investors who are convinced they can predict market movements better than everyone else because they're smarter. In financial jargon, that's called beating the market: earning a better return than the overall market.
They might buy shares in company X because it's launching an exciting new product and they expect the share price to rise. Or they sell company Y because its price has fallen sharply and they fear further losses. Fear and greed are powerful motivators - the fear of losing money and the desire for bigger profits. When most investors follow this herd behaviour, markets tend to overshoot. In the end, forecasts usually prove wrong: people buy at inflated prices and sell when prices are low.
Studies show that non-professional investors underperform the market by approximately 1 to 2 % on average. Even professional investors and fund managers generally fail to outperform once costs and market risks are taken into account, at least over the long term. This aligns with modern financial theory, which says share prices move randomly and can't be reliably predicted. If that's true, then professional analysis and sophisticated strategies add little long-term value.
There was a time when I believed some could. Take momentum investing, for instance - the idea that shares with strong past performance will continue to rise, at least for a while. But I've had to revise that view. It turns out such strategies only work in certain market phases. Outside those periods, they can actually underperform. And the bigger problem is: those phases can't be predicted.
Frankly, it doesn't - not fully. Buffett seems to be one of the rare exceptions who've found the key to long-term outperformance. But even he isn't immune to setbacks, as this year shows. The important thing to remember is this: it's easy to identify exceptional talent in hindsight, but almost impossible to spot it reliably ahead of time.
There's a well-known anecdote about Buffett: he once advised his wife to sell his Berkshire Hathaway shares after his death and to invest 10 % of the proceeds in government bonds and the rest in index funds.
Strategically. The first step is to ascertain how much risk you can objectively bear - and how much you can emotionally stomach. Broadly speaking, that risk profile determines your investment strategy, meaning how you allocate your money across different asset classes. The key decision is how much of your wealth to invest in equities, the riskiest asset class.
Think long term - not every market move calls for action.
The second step is humility: realising you're probably not smarter than everyone else. Once you accept that, it becomes clear that constant trading adds little value - apart from higher costs and the risk of bad timing. People who stop trying to beat the market are best off investing in low-cost index funds that cover a range of asset classes. In short: the key to success is diversification.
Diversification means spreading your investments across assets that don't move in the same direction. Losses in one share or asset class are offset by gains in another. In technical terms, that's called low correlation. If you knew the expected returns and correlations of all your investments, you could - at least in theory - use computing power to build a mathematically optimal portfolio. The beauty of diversification is that it reduces investment risk without having to forgo returns.
True. Fortunately, you don't need complex models to benefit from diversification. Simply avoiding major concentration risks goes a long way. You can put a smaller or larger share of your assets into equities - depending on your personal risk profile - and spread the rest evenly across bonds, real estate and commodities to build perhaps not a perfect portfolio but a very good one, with relatively little effort.
More or less. Once your portfolio is in place, you should think long term and resist the urge to keep reshuffling it. Rebalancing only makes sense when you add or withdraw funds, when your risk profile changes or when market movements have thrown your portfolio out of balance.
It's not entirely easy, but it's not that complicated either - if you take a pragmatic approach. Neutral, expert advice can be invaluable - whether in defining your risk profile, assessing investment products, handling tax questions or adjusting your portfolio as your life changes.
About Martin Weber
A Senior Professor at the University of Mannheim's Faculty of Business Administration, Martin Weber's research focuses on modelling psychological behaviour in financial decision-making and examining how people make investment choices. His most recent book explores rational thinking as the key to investment success and how psychological biases can prevent investors from implementing a sound strategy.
