What to avoid when you are investing

Makueni Governor Kivutha Kibwana (standing) and Senator Mutula Kilonzo Junior during a past stakeholders’ forum on the Konza Technopolis. Photo/FILE  NATION MEDIA GROUP

By SAMORA KARIUKI

In Summary

• For investors, a good handle or awareness of the psychological biases that influence your life, not only investment is required. Emotional intelligence therefore is crucial for investment success.
• In short, do not invest on the basis of stock tips received whilst sharing a beer with your friends. inShare

When even shoeshine boys are giving you stock tips, it is time to sell. This comment made by Joseph P. Kennedy, the father of the former US President would ring a bell to a number of Kenyans who invested in the Stock Market between 2004 and 2007.

Numerous retail investors lost fortunes participating in an endeavour that they barely understood. The boom is evident in the fact that 10 IPO’s conducted since 2000 occurred during this period.

Indeed, the ensuing crash led to the disappearance of the retail investor from the Nairobi Securities Exchange, with most activity nowadays being dominated by foreign and local corporate investors.

The decline in retail activity has been brought about by a number of issues. Specifically, the fall of a number of stock-brokers, the increasing appeal of the real estate sector and some issues of corporate governance amongst some listed companies. However, there is an element of psychology that has affected retail investor participation at the bourse.

A recent working paper at the Cleveland Fed entitled “Friends Do Let Friends Buy Stocks Actively”, shows that increased social activity leads to more active investment by investors. In essence, the more sociable you are, the more likely you are to trade your portfolio more actively.

Further research has shown that higher returns lead investors to be more sociable and engage in more conversation with other investors.

A study in 2009 showed that in Taiwan, retail investors underperform the market by an average of 3.8 per cent and accumulate losses that sum to 2.2 per cent of Taiwan’s GDP. This is a startling statistic that shows the adverse effects of active portfolio management on wealth creation. If the same statistics applied in Kenya, then it would mean that active investors lose about Sh9 billion per annum.

Numerous studies have shown a link between investor activity and wealth erosion.

Socialising is important in a number of domains, career advancement, marital stability, academic success and even business success to name a few are some of these domains. However, it seems that investing is not one of them. Through socialisation, one is likely to get caught up in investment fads or feel the urge to “keep up with the Joneses”.

Even professional fund managers are liable to this “socialisation bias”. As Warren Buffett aptly puts it “time is a friend to the fundamentalist and a foe to the faddist”; in this case, the faddist being the overly active investor.

A casual reading of the above would seem to suggest that I am advocating for retail investors to passively invest in the stock market through mutual funds and other such professionally managed investment vehicles. Actually, this is not the thrust of the argument. The key take-out is that an understanding of the psychological biases that inform investment decisions is critical to make good decisions.

For investors, a good handle or awareness of the psychological biases that influence your life, not only investment is required. Emotional intelligence therefore is crucial for investment success.

Retail investors should take note that over the really long run, when dividends and capital gains are accounted for, stock markets tend to do better than real estate.

Retail investors should therefore troop back to the stock market carefully with the knowledge that a “socialisation bias” exists and it is likely to erode your wealth. In short, do not invest on the basis of stock tips received whilst sharing a beer with your friends