The Seven Deadly Sins were formulated in early Christian teachings to make followers mindful of man’s natural vices.
Those vices can be particularly applicable when making investments, the activity being rife with opportunities to fall into bad habits, be led astray or make decisions for the wrong reasons.
However, being aware of the behavioural traps and temptations that lie in wait for the unwary investor is the first step to avoiding them.
LUST: Resist the siren call of short-term opportunity
Investing for the long term sounds like an obvious strategy but it is surprising how few investors do so. In our fast-paced world, the desire for instant gratification can overwhelm. The prospect of immediate gain invites attempts to try to “time” a sector or stock – often with disastrous consequences – or to pile into whatever is the flavour of the month long after the opportunity to profit has passed. Equally, the urge to crystallise profits can cause quality assets to be sold well before they reach fair value.
Moving in and out of markets or asset classes can suggest an active passion for investing but often incurs only losses as well as the ubiquitous trading costs.
A less lusty approach that weathers market ups and downs over years, not just weeks, nearly always proves more fruitful, as well as cheaper, in the long term.
GLUTTONY: When it comes to information, less is often more
In a data-overloaded world, it is easy to gorge on information. Simpler but disciplined analytical frameworks can be the most robust. When evaluating asset classes, for example, the simplest approach is to look at yields and growth prospects. If valuations are high (and therefore yields are low), the chances are that valuations will fall (and therefore yields will rise). Conversely, if yields are high there is a good chance that they will fall and valuations rise.
Having the discipline to screen out market noise also means resisting the temptation to change your basis for valuation every time a new fad comes along. People lost fortunes in the dot.com bubble by being attracted to fashionable new metrics such as counting eyeballs, instead of analysing company cashflow.
GREED: If everyone else is investing, it is probably best that you do not
The periods when a sector is rocketing and investors are piling in at any price can be the time to steer clear (or quietly sell). Conversely, the times when the market is getting agitated and bailing out can provide rich territory for smart, selective investors who know what they want to buy and why. Patience is paramount, however. If you have a strong conviction about a company or asset class, it may take a while for others to come round to your point of view. During this time, prices may move against you, requiring mental strength to stick with your position.
Equal discipline is required to keep your portfolio balanced. If everyone is moving to equities, it can be tempting to sacrifice your fixed-income exposure. But by doing that, you could also jettison your risk diversification.
SLOTH: There are no shortcuts in investment
It is important to invest only in what you really know and like. In fundamental equity investing, that means doing all the hard work to get to understand every company first-hand – finding out where performance is coming from and how it can be sustained in the future.
For bonds, do not look only at yield. Measure it against other valuable criteria, such as default rates or the underlying nature of the company and industry (or economy).
Only through this grunt work will you really understand what the right valuation for an investment should be.
From some vantage points, sloth is one of the better sins. Once a business is chosen in which to invest, it is often best to let the stock grow without fussing over it or trading unduly.
So the moral is not to be lazy in carrying out due diligence but to rest comfortably once a sound long-term decision has been made.
WRATH: Being diversified is the key to remaining calm, even in volatile markets
Markets are plummeting, the outlook is bleak and everyone is selling. But if your portfolio is properly diversified, you can afford to be an oasis of calm. There are rare cases when the majority of asset classes have fallen in tandem (the 2008 global credit crisis) but usually it is a case of swings and roundabouts.
If equities are falling and interest rates are being cut, your exposure to fixed income is likely to be standing firm. Equally, if inflation is threatening to rise, equity and commodity exposure may hold you in good stead even if your bond holdings fall.
The wrath and unpredictability of markets can be daunting. Allocating to the highest-quality assets you can find across a spread of lowly correlated asset classes remains arguably the most sensible protection.
ENVY: Imitating the index is the poorest form of flattery
“Benchmark hugging” is a cardinal sin of the active investor. This deviant behaviour, especially among professional investors, is driven largely by fear. After all, if you follow your benchmark index, at least you cannot be sacked for under-performing it.
The sin is partly that it is lazy and unthinking. It means constantly investing only in assets that have done well in the past, rather than in those that might do well in the future (stocks only enter indices following good performance and leave after poor).
When constructing a portfolio, it may be a good idea to take little or no notice of market indices but to invest in assets that offer the best potential for future return at an appropriate level of risk. This gives you the freedom to invest only in what you really rate, with no obligation to hold anything simply because it is in the index.
Modern multi-asset strategies judge their performance not against a relative market index but against the tangible and absolute concept of a risk-free return – like cold, hard cash. For many risk-averse investors, that is a benchmark well worth outperforming.
PRIDE: Over-confidence comes before a fall
The natural tendency to be over-confident in one’s abilities is fatal for investors. It leads them to make judgements based on inadequate information, over-estimate the accuracy of their predictions and believe they are not prey to the same mistakes as everyone else. Over-confident investors often make the same mistakes again and again.
What is more, people often remain over-confident even when they have made mistakes that highlight the errors of their judgement. In these circumstances, they are likely to blame events outside their control. So when an asset in a portfolio goes up, an investor is likely to take the credit. When it falls, they are more likely to blame unforeseen events.
Spending more time asking yourself why your judgement could be wrong, rather than gathering proof that it is right, can lead to a better outcome.
The virtuous approach
Being a virtuous investor is a challenge. It demands that you resist impulsive behaviour, screen out market noise, remain thorough in your research and stay calm and dispassionate whatever market conditions you face.
But armed with the knowledge of which vices to avoid, hopefully those good habits will become a little easier to cultivate.
Mike Turner is head of multi-asset at Aberdeen Asset Management