Three Surprising Investing Mistakes You Want to Avoid

Posted by Alex Frey (@alexhfrey )

One of the great tragedies of the financial world is that while the stock market has returned an average of 10% a year over the past century, the average investor has struggled to even keep pace with inflation. If you aren’t feeling as rich as you think you should be, here are three possible reasons why.

You Are Using Your Brain Too Much

The brain evolved in an environment where man was constantly under threat. While co-existing with lions and tigers on the African serengeti, over-reacting to outside stimuli was generally a vastly superior strategy to taking a more more measured and reflective approach. When something resembling a lion seemed to be approaching your cave, there was a lot of downside to pausing to gather your thoughts for a minute, and little downside to grabbing whatever sharp object was handy and running.

When choosing stocks and bonds, that same desire to react to whatever has happened to us lately works less well. Study after study has shown that investors that more frequently “tinker” with their investments dramatically underperform those that pay less attention to them. This is true of retail traders with discount-brokerage accounts, it is true of investors in mutual funds, and it is even true of the professional investors that run mutual funds!

One way to avoid making overly spontaneous investment decisions is to stick to a pre-designed investment philosophy, or system. Many hedge funds have sophisticated quantitative models that pick investments based on objective criteria alone, taking emotion, "hunches," and even human intuition entirely out of the process. 

While complex trading models may be out of reach to the individual investor, anyone can put their investments more or less on auto-pilot by designing their own investing system. You just need a universe of investments you are going to stick too, a buy criteria, a sell criteria, and a set frequency to rebalance your account. This way, just about all of the "thinking" required to invest can be done ahead of time, when no lions are charging your cave. In the heat of the moment, you just have to react and follow your script. 

You Spend Too Much Time Thinking About Saving

In a now-famous experiment that has been quoted in a number of psychology texts, two sets of students were given identical tests that required a large amount of concentration. A plate of cookies was set out in front of each group before they took the test. One group was told they had to refrain from eating the cookies, while the other was given permission to dive in. Which group did better in the test? Surprisingly, the group that had to refrain from eating the cookies gave up on the concentration test long before the cookie eaters.

So eating cookies makes you smarter? What does this have to do with investing? Experimental psychologists ran this experiment to prove that willpower, such as the kind needed to refrain from eating cookies that are sitting in front of you, is a finite resource. Forcing ourselves to do things that we do not want to do expands a form of energy, and when the tank runs dry, our ability to control ourselves diminishes. 

Just about everyone agrees that most Americans are saving too little for retirement. But what if part of the reason is that we spend too much time thinking about saving?

If we are spending a lot of time dwelling on something, it is probably because it is something that takes willpower to do. Paradoxically, the more we think about saving, the harder it is for us to actually save. 

Thinking about saving without actually taking action is a pointless way to deplete willpower. One way to save more while also thinking about saving a lot less is to automate this process. Set up a company-sponsored 401(k) or IRA and have a percentage of your paycheck deducted every month. Once you have maxed these contributions out, open up an account at a discount brokerage that offers commission-free ETFs and start an automated investing plan, known as “dollar cost averaging.” You can construct your own diversified portfolio using as little as two or three ETFs. Sign up for mint.com and tell it to alert you when you are spending too much in a month and risk running out of money. Increasing the amount you are saving while decreasing the time wasted thinking about it is truly a win-win.

When It Comes To Money Matters, You Trust Your Gut

Anyone who has read Malcolm Gladwell’s famous book Blink knows that intuition can be a double-edged sword. Sometimes, such as when a grandmaster can instantly glance at a chess board and see a sequence of moves that produce a checkmate, the human mind can seem to do almost other-worldly things. Other times, such as when racism or unfounded stereotypes rear their ugly head, the brain can seem quite narrow and limited.

How can we tell when our intuitions are gold and when they are just noise from a brain hardwired for the African serengeti? In his amazing book Thinking, Fast and Slow nobel-prize winning psychologist and behavioral economist Daniel Kahneman writes that the development of a refined intuition requires “an environment that is sufficiently regular to be predictable” and “an opportunity to learn these regularities through prolonged practice.” What he means by “prolonged practice” can be illustrated by “10,000 hour rule”, which suggests that to develop expert-level intuitions at something takes 10,000 hours of study.

The takeaway: if you haven’t spent something approaching 10,000 hours studying stock market prices then your “hunch” that IBM is going to go up next week might not be worth all that much. Intuition is not magic. So what to do if you haven’t yet developed a refined intuition for picking stocks? There really is no shortcut here - do the analysis, and if you cannot do it yourself then run your ideas by someone that can. Or avoid this game altogether and invest in a diversified portfolio of ETFs or index funds. 


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By Alex Frey