In many areas of life, we are often our own worst enemies. The realm of personal finance is no different.
What’s the biggest threat to achieving financial independence?Unfortunately, it’s our own brain.
You can invest in all the right things, minimize fees and taxes, and even diversify your holdings. But if you fail to master your own psychology, it’s still possible to fall victim to financial self-sabotage.
What are the mistakes that ordinary investors make and how to counter them?
Mistake 1. Seeking confirmation of your own beliefs
Your brain is wired to seek and believe information that validates your existing beliefs. Our minds love “proof” of how smart and right we are.
Even worse, this is magnified by information we find online:
• News media (CNBC, Bloomberg, etc) tend to favor one point of view
• Google and Facebook filter our search results
• Unsubstantiated rumors can run unchecked, as long as they reinforce existing points of view
This can be exceptionally detrimental in investing.
Convincing yourself that a particular stock or strategy is correct, without taking into account contradicting evidence, can be the nail in the coffin of financial freedom.
The Solution: Welcome opinions that contradict your own
The best investors know they are vulnerable to confirmation bias, and actively ask questions and seek qualified opinions that disagree with their own.
Ray Dalio, for example, seeks the smartest detractor of his idea, and then tries to find out their full reasoning behind their contrary opinion.
Mistake 2: Conflating recent events with ongoing trends
One of the most common – and dangerous – investing mistakes is to believe that the current trend of the day will continue.
In psychology speak, this is known as recency bias, or putting more weight on recent events when evaluating the odds of something happening in the future.
For example, an investor might think that because a stock has performed well recently, that it will also do well in the future. Therefore, she buys more – effectively buying at a high point in the stock.
The Solution: Re-balance
Our memories are short, so what can we do?
The best way to avoid this impulsive and faulty decision making is to commit to portfolio allocations (i.e. 60% stocks, 40% bonds) in advance, and then re-balancing on a regular basis.
This effectively ensures you are buying low, and selling high. When stocks to well, you sell some of them to buy other assets in the underweighted part of your portfolio, and vice versa.
Mistake 3: Overconfidence
Very successful and driven people often assume they will be just as good at investing as they are at other aspects of their life. However, this overconfidence is a common cognitive bias: we constantly overestimate our abilities, our knowledge, and our future prospects.
The Solution: Get Real, and Get Honest
By admitting you have no special advantage, you give yourself an enormous advantage – and you’ll beat the overconfident investors that delude themselves in believing they can outperform.
Would you like to know which are the other mistakes?
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