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Want to become RICH? AVOID these 6 investing mistakes
The study of investors' behaviour offers some interesting mistakes you can recognise and avoid.
Finance professors aren't the first group of people you'd approach for investment advice. But if you end up in the same room with a couple of behavioural-finance economists, listen up.
They study the psychology and behaviours of investors to see where they make mistakes. If you learn to spot and correct these mistakes, it may mean greater profits.
Some insights behavioural finance has to offer read like common sense. It's no secret, for example, that many investors will focus obsessively on one investment that's losing money, even if the rest of their portfolio is in the black (profit). That's called loss aversion.
Other behaviours, though, are subtler, more difficult to spot, and harder to correct. Here are six such mistakes to avoid.
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Want to become RICH? AVOID these 6 investing mistakes
1. Overconfidence
Overconfidence refers to our boundless ability as human beings to think that we're smarter or more capable than we really are. One study found that 90 per cent of the automobile drivers in Sweden rated themselves above-average drivers. Moreover, when people say that they're 90 per cent sure of something, studies show that they're right only about 70 per cent of the time.
Such optimism isn't always bad. Certainly we'd have a difficult time dealing with life's many setbacks if we were die-hard pessimists.
However, overconfidence hurts you as an investor when you believe that you're better able to spot the next Apple than another investor is. Odds are, you're not.
Studies show that overconfident investors trade more rapidly, because they think that they know more than the person on the other side of the trade. Trading rapidly costs plenty, and rarely rewards the effort.
To avoid overconfidence in your own investing, document and review your investment record. It's easy to remember your one stock that gained 50 per cent in a single day, but records may reveal that most of your investments are under water for the year.
Want to become RICH? AVOID these 6 investing mistakes
2. Mental accounting
If you've ever heard someone say that they can't spend a certain pool of money because they're planning to use it for their vacation, you've witnessed mental accounting in action.
Most of us separate our money into buckets -- this money is for the kids' college education, this money is for our retirement, this money is for the house...
Investors derive some benefits from this behaviour. Earmarking money for retirement may prevent us from spending it frivolously. Mental accounting becomes a problem, though, when we arbitrarily divide the components of total return: income and capital appreciation.
Many investors feel that they can't spend capital appreciation -- that's principal -- but they can spend income.
Ironically, investors can erode their principal in a quest for generous income streams.
Take a bond fund that pays a high dividend, but generates a negative capital return. Your original investment would shrink, not grow, every year. Eventually, your dividends would shrink as well. That's because a bond fund's yield is nothing more than a percentage of its asset base. So even if a fund maintained, say, an 8 per cent yield, the amount of its dividends would fall if its capital returns were negative, eating away its asset base.
The best way to avoid the negative aspects of mental accounting is to concentrate on the total return of your investments, not simply one dimension of their return.
Want to become RICH? AVOID these 6 investing mistakes
3. Anchoring
Ask residents of Mumbai to estimate the population of Pune and there is a chance they'll anchor on a number they know -- the population of their city -- and adjust down, but not enough.
Ask people in Kolhapur to guess the number of people in Pune and they'll anchor on the number they know and go up, but not enough. When estimating the unknown, you cleave to what you know.
For investors, anchoring behaviour manifests itself in an unwillingness to part with laggard investments. Many time investors will cling to an investment waiting for it to 'break even', to get back to what they paid for it.
You may cling to sub-par investments for years, rather than dumping them and getting on with your investment life. It's costly to hold on to losers, though, especially in a taxable account: If you realise a loss, at least you can use it to offset realised gains.
Some behavioural finance professors recommend that you ask yourself: Would I buy this investment again? And if you wouldn't, why are you continuing to own it?
Want to become RICH? AVOID these 6 investing mistakes
4. Representativeness
This is a mental shortcut that causes you to give too much weight to recent evidence -- such as short-term performance numbers -- and too little weight to the evidence from the more distant past. As a result, you'll give too little weight to the real odds of an event happening.
5. Regret
You may not distinguish between a bad decision and a bad outcome. You'll feel regret after a bad outcome, such as a stretch of weak performance from a given stock, even if you chose the investment for all the right reasons. Regret can lead you to make a bad sell decision.
6. Fashions and fads
You may feel comfortable investing with the crowd, as in following a market guru or buying a popular mutual fund. Such behaviour can lead to fading performance or inappropriate investments for your particular goals.
Of course, it's easy to recognise irrational behaviours; correcting them is another matter entirely. Still, if the insights of behavioural finance lead you to at least think twice before committing an irrational act of investing, that's a start.