Psychological Mistakes Ordinary Investors Make
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 your 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.
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.
Mistake 4: Swinging for the Fences
It’s tempting to go for the big wins in your quest to build financial wealth. But swinging for the fences also means more strikeouts – many which can be difficult to recover from.
The Solution: Think Long Term
The best way to win the game of investing is to achieve sustainable long-term returns that compound over time. Don’t get distracted by the short-term noise on Wall Street, and re-orient your approach to build wealth over the long term.
Mistake 5: Staying Home
This psychological bias is known as “home bias”, and it is the tendency for people to invest disproportionately in markets that are familiar to them. For example, investing in:
• Your employer’s stock
• Your own industry
• Your own country’s stock market
• Only one asset class
Home bias can leave you overweighted in “what you know”, which can wreak havoc on your portfolio in some circumstances.
The Solution: Diversify
Diversify broadly, in different asset classes and in different countries. From 2000 to 2009, the S&P 500 only returned 1.4% per year, but other markets picked up the slack:
• Developed markets (ex US): 3.9% per year
• Emerging markets: 16.2% per year
A well-diversified portfolio would have done well, no matter what.
Mistake 6: Negativity Bias
Our brains are wired to bombard us with memories of negative experiences.
In fact, one part of our brain – the amygdala – is a biological alarm system that floods the body with fear signals when we are losing money.
The problem with this? When markets plunge, fear takes over and it’s easy to act irrationally. Some people panic, selling their entire portfolios to go into cash.
The Solution: Prepare
The best way to avoid negativity bias is to:
• Keep record of why you invested in certain securities in the first place
• Maintain the right asset allocation that will help you through volatility
• Partner with the right financial advisor to offer advice
• Focus on the long term, and avoid short-term market distractions
These simple rules and procedures will make it easier for you to invest for the long term.
They’ll help you:
• Trade in a more sensible manner
• Lower investment fees and transaction costs
• Be more open to views that differ from your own
• Reduce risk by diversifying globally
• Control the fears that could otherwise derail you
Will you be perfect? No.
But will you do better? You bet!
And the difference this makes over a lifetime can be substantial.