I spent the better part of five years trying to convince myself that I was a sophisticated do-it-yourself investor with a sound dividend growth strategy that would outperform the market over the long run. My dividend growth investment approach had performed well, delivering annual returns of 16% over a five-year period.
But after reading Thinking, Fast and Slow by behavioural finance expert Daniel Kahneman, I began to change my tune.
I recognized a whole bunch of hidden behavioural biases that clouded my judgement—framing, recency bias, home-country bias, and overconfidence. Here’s what they mean:
Framing: It can be difficult to part ways with a successful investing approach. Selling a portfolio of winning stocks—my babies that I had nurtured through a five-year bull market—just didn’t feel right. But if I was sitting on $100,000 worth of cash instead of stocks, I would have no problem starting a couch potato portfolio of index funds.
Recency bias: As the bull market raged on and my investments continued to perform well, it became harder and harder to recall what a bear market felt like and what I might do if my investment returns started to miss my goals.
A couple of years ago, my portfolio started to trail its benchmark by about one percentage point. It wasn’t huge but it was enough to make me reconsider my approach.
Home-country bias: When I started my DIY portfolio, I invested in the 10 highest yielding stocks in the S&P/TSX 60 Index. After refining my stock-picking approach, I still stuck with Canadian dividend payers even though Canadian firms make up a tiny slice of the global economy.
Making matters worse, instead of keeping my Canadian dividend stocks in a TFSA or non-registered account, they were held inside my RRSP. It’s not an optimal strategy when it comes to tax efficiency.
Overconfidence: It’s hard not to be overconfident when you’ve beaten your benchmark by a full three percentage points per year over a five-year period. But even the best investors will eventually suffer periods of underperformance.
Why wait for that to happen before accepting the inevitable? Indexing would give me the best chance of achieving my investment goals over the very long term.
There’s no shame in admitting that you’re not the next Warren Buffett. The vast majority of investors aren’t. Those who figure it out are likely to improve their returns dramatically by following simple low-cost mechanical methods such as investing in low-fee index funds.
Speaking of Buffett, he has famously touted the benefits of a low-cost, broadly diversified investment approach. He has said that most investors would be better off in an index fund rather than trying to beat the market by picking stocks or actively managed mutual funds.
It’s not that I stopped believing in my dividend growth strategy—it’s a fine approach that many investors can and do have success with—but wasn’t ideal for my RRSP. Also, the time and effort needed to manage it properly wasn’t worth my time in the long run.
The bottom line
The more I read about, write about, and teach others about investing, the more I’m convinced that passive investing is the right approach. That’s why I ultimately sold my dividend stocks and replaced them with two exchange-traded funds.
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Flickr: Iman Mosaad