The Great Investors Face Their Mistakes

A few days ago, I had lunch with a physician-investorinterested in transferring his assets.In our discussion, he brought up someknowledgeable points that seemed to indicate hisgood judgment. However, while discussing his previousinvestment experiences throughout the years,he made a few statements that inspired adifferent opinion. As I finished off thelast of my lunch, I couldn't help butreflect on a common investing qualityassociated with poor judgment or shakethe feeling that I was staring across thetable at one of its victims.

THE WINNER'S SYNDROME

Throughout our conversation, thephysician frequently discussed how wellhe had done in the past. He explainedto me in detail how he had made greatgains in the late '90s and how he hadcashed out of specific investments early.In his mind, this physician-investor hadsuccessfully managed to guide his portfolioto victory. And, obviously, hehad—reaching the top of his game andwinning in the market.

So, what's wrong with sharinginvestor war stories over lunch, especially whenthey're happy? Usually nothing. Most investorsenjoy patting their own backs every now and then,especially when it's well deserved. However, duringthis particular conversation, it wasn't so muchwhat my lunch partner said; it was what he didn'tsay. And that's what inspired my reflection on theterm "cognitive dissonance," which, unfortunately,seemed to have taken my physician-investorcolleague out to lunch.

Cognitive dissonance is a fancy psychologicalterm that means your brain ignores or lessens negativeinformation and fixates on the positive.Evidently, the brain does this to preserve our self-image;it's a protective strategy. To endure the realityof some of our poor decisions would cause toomuch pain. Therefore, we ignore negative evidenceor attenuate it by not recognizing thewhole truth. And although I didn'tknow my lunch partner that well, itseemed obvious to me that he dabbledheavily in cognitive dissonance.

A PROBLEM'S PROBLEM

While cognitive dissonance may notlead to eventual financial demise, lack ofrecognition can influence our decisionprocesses adversely. First, we may notmake necessary decisions because it istoo uncomfortable to contemplate facingunfavorable results. For example, wemay not keep accurate documentationof our investment results so that wedon't have to face the possibility of apoor outcome. Unfortunately, this typeof behavior can spell trouble forinvestors. Knowing our results usuallyhelps us invest better in the future.

In addition, we tend to sift through new informationto accommodate our beliefs that our previousdecisions were better than they really were. Inother words, we change our beliefs to suit our self-imageand not the facts. To illustrate this commonconsequence, a group of architects was asked toestimate the return in their pension plans the previousyear. They recalled their investment performanceas 6% higher than the actual return.Furthermore, they estimated that they had beatenthe market by 5% more than they actually had.Other studies have been performed with educatedinvestors, and the results have been similar.

So what does cognitive dissonance have to dowith you? Hopefully nothing. However, beingaware is the key to resistance. And although it ishuman to yield to cognitive dissonance, it is literallydivine to resist it. This means that objective figuresare necessary in terms of your investment performance.Not only do you need to know how wellyour portfolio performed in reference to its appropriatebenchmark, but you also need to know itsrisk-adjusted return. This is because the risk-adjustedreturn tells you if you are being compensatedin terms of return for the risk you're taking.

How do you find this data? Most of the time it'sdifficult, unless your investment advisor keeps trackof it for you and provides you with the informationregularly. This is 1 advantage of a good investmentadvisor. Ask them for this data if you're currentlyworking with one. It's much easier than trying tofind the data yourself. However, if you don't havean advisor and are interested in doing the legworkrequired, there are some useful Web sites you canvisit (see the sidebar for more information). By takingthe time to know objective results about yourinvestment performance, you don't have to accommodateyour beliefs about it. Ultimately, this canonly lead to better investment results for you.

A tutorial on risk-adjusted return: www.finportfolio.com/education/tutorial/tutorial_risk-adjusted_return.html

Information on the Sharpe ratio, which measuresrisk-adjusted returns: www.investopedia.com/terms/s/sharperatio.asp

A Web site that offers risk-adjusted return oncertain managers for a modest fee: www.managerreview.com

Shirley M. Mueller is

boarded in neurology

and psychiatry. She

was a practicing neurologist

until 1995.

Since then, she has

retrained and is active

in the investment and

financial planning area.

Dr. Mueller is a senior

wealth advisor at Star

Wealth Management

in Indianapolis, Ind.

She welcomes questions

or comments at

MyMoneyMD@aol.com.