Do you trade stocks several times a year?

Do you regularly check your trading or retirement account to see how your investments are performing?

Do you look to the financial media for ideas on which stocks or funds to invest in?

Do you feel the urge to trade again if the last trade you made was either a big success or a real flop?

If you answered Yes, to any of these questions, the chances are that you've lost control of your investment decisions.

Of course, investors like to think that their decision-making process is thorough and rational. But the evidence tells us it can be anything but.

Behavioral finance is a relatively new academic discipline, devoted to explaining why we make the financial choices we do. Studies have highlighted a whole range of behavioral biases that lead to sub-optimal investment decisions.

These include confirmation bias, or the tendency to seek, interpret, and remember information that confirms pre-existing beliefs while ignoring contradictory data. Then there's herd behaviour, which refers to the way we follow and copy what other investors are doing. Also common is loss aversion, the preference for avoiding losses over acquiring equivalent gains.

But, as Mark Hebner explains in his book Index Funds: A 12-Step Program for Active Investors, whose tenth edition was published recently, there is another reason why investors make such poor choices: addiction.

Addictive trading

Several studies have suggested a connexion between addictive behaviour and, in particular, over-trading, drawing parallels to gambling disorders. These studies highlight similarities in motivations and personality traits between gamblers and stock traders, such as sensation-seeking, risk-taking, impulsivity and emotional instability.

The technological advances in trading platforms have made access easier, which can fuel addictive tendencies in individuals prone to risky behaviors. The inability to regulate stress and control impulses are also key factors contributing to the vulnerability to addiction to trading, similar to gambling.

A 2013 study by behavioural economists Arvid Hoffmann and Hersh Shefrin showed that around 2.5% of investors behave as if they were addicted to gambling. The same two academics have since conducted research on investors trading options on sites like Robinhood and found that frequent traders tend to incur significant losses.

"In the data which Hoffmann and I use," writes Shefrin, "20% of investors trade options actively and 12.5% stipulate that speculation is their primary motive for trading. The intersection, investors whose primary motivation for trading is speculation, and who use options to do so, comprises about 5% of our data sample.

"This group has terrible investment performance, on average earning 27% less per year than investors who are non-speculators, which of course means incurring large losses."

These findings are entirely consistent with similar research conducted over many years. "Repeated studies," writes behavioural finance expert Sarah Newcomb, "including Morningstar's annual Mind the Gap report, demonstrate that investors who actively trade tend to underperform the market".

There is also evidence that investors would like to exercise more self-control. In 2011, Barclays Wealth commissioned a global survey of high-net-worth investors around the world. 41% of them said they wished they were more disciplined in their financial behavior. This need for increased self-control was likely to be felt most by those at the wealthiest end of the scale, i.e. those with more than $16 million in assets.

Four self-control strategies

So, what if you recognize these addictive tendencies in yourself? What can you do to improve your investment decision-making in future? Here are four suggestions.

1. Stop checking your trading account

   The more you check your trading or retirement account, the more likely you are to act. The simplest solution is not to look at it, or to check it only once or twice a year. Certainly don't stay logged in, and perhaps use a random password that you won't easily remember.

2. Avoid the financial media

   Financial publications and websites are always churning out enticing stories to persuade you to invest, or not invest, in something or other. They also speculate about future market movements and catastrophize when markets fall. This is all unhelpful noise, so block it out.

3. Allow yourself a cooling-off period

   Many investors are prone to make rushed decisions and act on them before they've properly thought about it. If you're tempted to trade on impulse, stop yourself. Take time out. At the very least, sleep on it. Preferably wait several days before making a final decision.

4. Seek the opinions of others

   If you're thinking of trading, speak to a trusted friend about what you're planning to do and ask them to play devil's advocate and try to dissuade you. Remember, the financial markets are fiercely competitive, and there are two sides to every trade. A trader can only win at another trader's expense.

A better solution

But although all of these self-control strategies can help, they aren't guaranteed to work. We're all human after all. A far more robust strategy is to stop actively trading altogether and find yourself an evidence-based financial adviser.

The fact is that beating the market by predicting the future and picking the right investments at the right time is extremely difficult. Only a very  small proportion of investors manage to do it in the long run, and that includes the professionals.

Passive investing — in other words, buying and holding globally diversified portfolios of passively managed funds — is much more sensible.

Thankfully, there's a growing number of advice firms, like Index Fund Advisors, that realize this, and that's the sort of firm you need to engage with.

A lesson from Greek mythology

But just because you use passively managed funds, that doesn't mean you will automatically achieve your investment goals. Passive investors are also prone to make mistakes, act on their emotions and pay too much attention to the financial media.

In his book, Mark Hebner says the best thing you can do is to make what's called a Ulysses pact with your advisor.

In Homer's poem The Odyssey, the hero Ulysses devised a plan to avoid the distraction of the Sirens during his journey home from the Trojan War. The Sirens were mythical creatures known for their enchanting voices and music, which lured sailors to their doom.

Knowing the danger posed by the Sirens' song, Ulysses ordered his men to plug their ears with beeswax so they would not hear the song.

But, curious to hear the Sirens' song himself without succumbing to its spell, Ulysses had his men tie him to the mast of the ship and instructed them not to release him no matter how much he pleaded.

As the ship sailed past the island of the Sirens, Ulysses was enchanted by their song and, true to his prediction, begged his men to release him. But they obeyed his original orders and kept on rowing until the Sirens were out of earshot and danger had passed.

What you really need as an investor, says Hebner, is your very own Ulysses Pact, in the form of an investment policy statement, which acts as a strategic agreement between you and your financial advisor.

"An advisor," he writes, "can guide clients through the murky or turbulent waters and ensure they don't jump ship in response to the noise. This allows investors to agree up front that they will not act on emotions that can lead to irrational and wealth-destroying decisions."

So, if your future financial security is important to you, why leave it to chance? Sign a Ulysses pact with an evidence-based advisor. It could mean the difference between achieving your goals and not.

 

ROBIN POWELL is a financial journalist and editor of The Evidence-Based Investor.

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This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal.  For more information about Index Fund Advisors, Inc, please review our brochure at https://www.adviserinfo.sec.gov/ or visit www.ifa.com.