The Six Biggest Investing Mistakes

Money magazine lists the six biggest investing mistakes. Before I list them, let me say that I've made almost all of them (I've never made the last one, but the others I certainly have.) Anyway, here's their list and my comments:

Mistake #1: Overconfidence -- In recent years, a group of behavioral psychologists and financial economists have created the important new field of behavioral finance. Their research shows that we are not always rational. We tend to be overconfident. If we do make a successful investment, we confuse luck with skill. It was easy in early 2000 to delude yourself that you were an investment genius when your Internet stock doubled and then doubled again.

I made this one big-time. I used to think I was smarter than everyone else, could analyze data better than anyone else, and could pick stocks better than anyone else. Then I was in the market for a year or so and learned otherwise. ;-)

Anyway, this is the #1 mistake I see in beginning investors. They think that in their spare time they can somehow make better investment decisions than people who spend their lives picking investment (and these people, BTW, aren't that great at it either -- see mistake #5.)

Mistake #2: Following the herd -- People feel safety in numbers. Investors tend to get more and more optimistic, and unknowingly take greater and greater risks, during bull markets and periods of euphoria. That is why speculative bubbles feed on themselves.

I have made this mistake but not often. I've always been a go-against-the-flow or contrarian sort of person anyway, so investing this way was natural for me early in my investing days. Only it didn't work out much better than the herd group.

Mistake #3: Timing the market -- Does the timing penalty - the cost of second-guessing the market - make a big difference? You bet it does. The stock market as a whole has delivered an average rate of return of 9.6% over long periods of time. But that return measures only what a buy-and-hold investor would earn by putting money in at the start of the period and keeping his money invested through thick and thin. The average investor's actual returns are at least two percentage points lower because the money tends to come in at or near the top and out at or near the bottom.

"The money tends to come in at or near the top and out at or near the bottom." Ha! People will say over and over again that they can time the market, but if you look at the facts, they can't. They pull money out at the wrong time (after the market has tanked big-time) and finally decide to get back in once most of the run-up is done. If, by some amazing piece of luck, you were able to get out before the market declined and then to plow it all back in anywhere near the bottom, consider yourself extremely lucky -- and one in a million if not more. Something you certainly can't count on as a long-term strategy.

Mistake #4: Assuming more control than you have -- Psychologists have identified a tendency in people to think they have control over events even when they have none. That can lead investors to overvalue a losing stock in their portfolio. It also can lead them to imagine trends when none exist or believe they can spot a pattern in a stock chart and thus predict the future. In fact, the changes in stock prices are very close to a "random walk": There is no dependable way to predict the future movements of a stock's price from its past wanderings.

If you've been in the market for more than a week you know that you have very little control of what's going on. I wonder why it took me so long to learn this lesson.

Mistake #5: Paying too much in fees -- There is one piece of investment advice that, if you follow it, can dependably increase your returns: Minimize your investment costs. We have spent two lifetimes thinking about which mutual fund managers will have the best performance year in and year out. Here's what we now know: It was and is hopeless.

Yep. People pay fund managers and end up earning less. Fact of life. That's another reason I like index funds -- MUCH lower costs.

Mistake #6: Trusting stockbrokers -- The stockbroker's real job is not to make money for you but to make money from you. Brokers tend to be friendly for one major reason: It gets them more business.

I've met several smooth-talking brokers in my day and fortunately I've never been hooked by one. But if you ever are, they will certainly do something -- they'll work hard to make your money their money. Other than that, you probably won't get much value from them (see #5 again.)

At this point, my investments are on cruise control. I invest in index funds with a handful of funds designed to keep costs at a minimum. I bought all the way down (and back up again) during the recent decline and those investments are doing very well now. For the future, the formula is simple: keep saving, keep investing, rebalance, and adjust asset allocations when called for. These simple steps are all my portfolio calls for these days. It's kinda nice. ;-)

Comments

[Pop]

Great summary. One thing that I might add about the story is that it's actually a book excerpt written by Princeton professor Burton Malkiel and investor Charles Ellis. These guys are some of the major theorists behind what we know about stocks today.

[MasterPo]

MasterPo would add:

- Don't listen to "experts" on MSNBC, CNN, Fox Business etc. They know nothing more than you do.

- It follows from above that when you make a decision stick to it; Don't second guess yourself.

- If your decision works don't pat yourself too much on the back, as much as you think you made a good move chance played a big roll too; Similarly, if your decision turns out to be a bust don't beat yourself up either. Somethings you just can't control. And the market is far from rational.

ps- MasterPo agrees with #5 & #6.

[Eugene Krabs]

Hi, I'm an anonymous internet reader fancying himself as a popular children's cartoon character about a penny-pinching crustacean...

and I approve of this message.

[Cory]

It's a myth that more money goes into the market at the top and less goes in at the bottom. By definition, money in and out of the market must be constant plus IOPs as there is always a buyer and a seller of each share of stock. It may be true that mutual funds see the biggest withdrawals at the bottom and the highest inflow at the top but someone has to be on the other side of the trade.

[Cory]

Whoops, I said that wrong. Money in the market obviously goes up when the share prices go up. However, sideline cash stays constant. Often times you will hear people erroneously say that there is a lot of cash on the sidelines in down markets but that is a myth.

[mashford]

Thoughts on the couch potato ... 10 speed?