As human beings, our brains are booby-trapped with psychological barriers that stand between making smart financial decisions and making dumb ones.
The good news is that once you realise your own mental weaknesses, it’s not impossible to overcome them.
You're watching the market closely and see that a certain stock has been tanking over the last few months. You give it another month, watch it drop again and decide to sell it off before history repeats itself.
What's really going on: Gambler's fallacy.
When investors rely on past events to predict the future, they're shooting themselves in the foot. If a stock is flying or floundering for a year, that doesn't mean it will continue to do so in the year or even few months to come.
The same thing happens when you buy a lotto ticket because your buddy next door just won $US10,000 in a drawing. Just because he won doesn't change the odds of you winning at all.
Keep your decision making grounded in the real facts. Analyse your investments before making any sudden moves or following trends.
It's April 2008 and the stock market has just hit rock bottom, taking half of your retirement savings down with it. Shell-shocked and devastated by the loss, you demand that your financial advisor pulls every last investment out of the market immediately.
What's really going on: Loss aversion.
Loss aversion plagues even the most experienced investors, making them avoid potential gains because they're too afraid to take a risk.
Anyone who ditched the stock market for fear of further losses after the 2008 crash can blame loss aversion. The average pre-retiree 401(k) balance actually doubled since the recession. People who fled the stock market nad never rebalanced their portfolios only rebounded by 25%.
Loss aversion can also have the opposite effect, causing investors to cling too tightly to losing investments. Because it hurts to admit that they picked a loser, they focus on selling off winners and hope the losers will rebound over time. If they aren't careful, they wind up with a portfolio full of duds.
You're a savvy investor and you know you've got the goods to beat the market. So you jump in and start trading like a madman, trusting your gut and your own due diligence not to lead you astray.
What's really happening: Overconfident investing.
It takes seriously overconfident investors to kid themselves into thinking they can beat the market when even the people whose full-time job is to beat the market fail so frequently.
Terrence Odean's oft-mentioned study, 'Trading is Hazardous to Your Wealth,' isn't just a cute bedtime story for investors looking to stroke their egos. It actually shows that frequent trading caused by overconfidence can kill your returns.
Of more than 66,000 households using a large discount broker in the mid-1990s, those who traded most often (48 or more times a year) saw annual gains of 11.4 per cent, while the market saw 17.9 per cent gains, Odean found.
You're still working on building up your emergency fund and you just got a birthday check for $US100. Instead of adding it to your savings account, you treat yourself to a new coat or a haircut.
What's really going on: Mental accounting.
Mental accounting takes place when we assign different values to money depending on where we get it from. If you had earned that $US100 by working overtime one week, chances are you'd treat it more like regular income and save it.
Mental accounting is a big reason why we spend more money with credit cards than using hard cash. It just feels 'less' like money to us and therefore it's much easier to spend.
Instead, repeat this mantra: 'Money is money, no matter how I get it.' And the next time you use your credit card, ask yourself if you'd be spending that money if you were using cash instead. If the answer is no, hold off.
A housing development in your county just went belly up and you've heard investors are snapping up cheap plots for a steal. You've got no experience flipping houses but what the hell? You're not about to miss out on a hot ticket like that.
What's really going on: Herd mentality.
You've spotted a hot trend and you don't want to be the only schmuck out there who didn't book a seat on the bandwagon. As human beings, it can be very uncomfortable standing still while the rest of our peers head the other way looking like they're having a ball. It's in our nature to want to join the party.
This causes a lot of problems when it comes to investing. If you're willing to change course every time the herd moves, you'll end up trading a lot more frequently and seeing your returns nibbled to bits by transaction costs alone, not to mention what will happen if the herd leads you astray.
Cotton on to a trend too late and you'll just lose out when the herd moves on to hotter territory later on and your stock plummets. It's just a vicious cycle that will only lead to selling low and buying high.
The only way to profit from a trend is to get there before anyone else and the odds aren't in your favour
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