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Seven Habits of Highly Defective Investors & How to avoid them all.

7.jpgRecently I read an article by Paul Krugman titled “No Free Lunch; Seven Habits of Highly Defective Investors”. He had written this in 1997 just after the Asian crisis. His view was that even Money Managers who managed millions of dollars were no exception to making these mistakes. Though his article is based on his views of how money managers behaved it is a wake-up call to retail investors who blindly hand over money to them.

  1. Think Short Term – When it comes to investing the focus of most analysts is what the company is going to earn in the next one year. Rarely, we do have analysts who take interest in knowing the earnings in the next 5 years.
  2. Be Greedy - Most fund managers knew that the market was expensive and valuations are over stretched, but they preferred to stay invested a little longer.  They also felt confident that they can sell before the market plunges.  This strategy of trying to get those few extra percent can be a very expensive proposition.
  3. Believe in the Greater Fool theory – You know that buying a stock is expensive and you still buy it because you think that tomorrow someone else will buy from you at a higher price. This is still not an exception to even Money Managers as they too participate and buy the fancy stocks so they do not underperform the market.
  4. Run with the Herd – Very few people would like to take a decision and go in for companies which are not popular. This was also noticed among many fund managers who liked to go in for the same stocks which are part of a broader index or widely held by other fund managers.
  5. Over-generalize – This is another trend noticed among investors and also money managers. We tend to generalize based on the past experiences with investing in a company. For e.g. Just because one PSU company is not very efficient we cannot label all PSU companies are inefficient.
  6. Be Trendy – Many analysts like to be trendy and they always like to project that good growth in the past is likely to continue in the future as well. In reality this seldom happens and we rarely see a straight line growth in companies or economy.
  7. Play with other people’s Money – Most money managers are employees and are working in a career. In this position it is hard to take a long view. To be wrong when everyone else is wrong is not such a terrible thing: they may lose a bonus, but probably not their job. On the other hand, to be wrong when everyone else is right is a disaster. So everyone focuses on the same short-term numbers, tries to ride the trends.

A retail investor needs to be aware of these habits shown by professional money managers before signing their checks to them.

PAUL KRUGMAN is a professor of economics at the Massachusetts Institute of Technology. He was awarded the Nobel Memorial Prize in Economic Sciences in 2008.

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