Every wealthy investor has “skeletons” in the closet. Stories about bad investment decisions made, money lost, opportunities missed, market signals ignored.
Often these skeletons can be traced back to “emotional errors”: illogical, emotion-driven thinking that supersedes rational investment analysis. Such errors can severely limit portfolio returns and prevent investors from reaching financial goals. Allow me to describe some of these mistakes, and provide some suggestions to help you avoid them.
Many wealthy investors overestimate their ability to understand the markets. Some believe they can predict market movements; others think they can “beat the experts” at stock picking. This can be an issue with wealthy business owners, who sometimes assume business success translates “verbatim” into investment success.
A young high-tech entrepreneur I met at a conference several years ago is a case in point. Back in 2000, he sold his software company for more than $10 million. He subsequently made a substantial “angel” investment in a single dot-com startup. He was confident he had a good read on the company and its management. Things did not work as planned, and he lost a good chunk of the wealth he had built.
Before you commit to any investment, make sure to conduct a thorough “what if” analysis. Keep a close eye on concentration risk: if you’re looking to preserve capital and reduce risk, a single position should be no more than 10% of the market value (not cost) of your portfolio. Beyond that, consider rebalancing or hedging.
Losing money is difficult for even the best investors. But some take it to another level, refusing to acknowledge that an investment hasn’t worked out as planned. They hang on to “dead money” positions even when there is little chance of recovery.
A colleague of mine told me a story about a smart, capable executive who was exceptionally good at identifying business opportunities and business challenges. This client had no problem divesting businesses that weren’t performing, but with his investment portfolio, things were different.
In it, the client routinely hung on to positions years after they had dropped in value.
There is nothing wrong with changing an investment decision if the economic climate or the underlying business has changed. In our practice, we set a line in the sand: if an investment drops by 15% of the initial investment amount, we re-evaluate our assumptions. If we still believe in the investment, we ask ourselves: “If we had a new dollar today, would we still buy this position?” If yes, we buy back in. If not, we move on.
Some people treat investing as a game: the potential for loss generates excitement rather than anxiety. Yet these people still have “normal” financial goals: a secure retirement, sending kids to university, making charitable gifts, etc. These goals are completely inconsistent with a high-risk approach.
Years ago I had a wealthy client with a large portfolio heavily invested in venture market stocks. He was an active trader, jumping in and out of positions several times. Most of these trades were losers. But one out of every dozen would work out and give him more and more confidence. Eventually, I resigned the account. The client wasn’t looking for a wealth manager; he was looking for a gambling buddy.
It’s exciting when a high-risk investment makes money. But you need to limit the impact of such risk-taking on one’s overall portfolio. If you want to speculate, divide your portfolio into two segments: “serious money” and “play money.” The latter should be no more than 10% of your liquid net worth.