#88 Common Investment Mistakes
In this post we will cover common judgment errors that we make while making investment decisions.
Psychology of Poor Investment Decisions
Investments decisions are most commonly affected by:
Overconfidence
Optimism
Denying random events and the regression to the mean
Anchoring, status quo, and procrastination
Prospect theory
Overconfidence
Overconfidence leads to - excessive surety that you know which direction the market is headed, assurance that you can pick the right fund in which to invest, and a more active investing strategy. Expenses associated with an active investing strategy can add up to a surprisingly large amount of money over time.
Optimism
Motivated optimism and the confirmation bias convince people with money in the market that their investments have a bright future. Investors consistently predict that their portfolios would grow faster for the next six month interval than they actually did. Investors also have optimistic illusions about past performance of their investments (assume higher returns than actually obtained).
Denying that Random Events are Random
Investors attribute past fund outperformance to the skill of the fund manager. Investors expected their portfolios' future performance to be highly correlated with past performance. Investors overestimate the influence of individual skill and underestimate the role of chance.
Anchoring, Status Quo, and Procrastination
Investors typically think too little about the type of investments that they want in their investment portfolios. Once an investment decision is made it is never adjusted - even as their life circumstances changed over time. Status quo bias prevented investors from switching to investments that best suited their particular needs. The bias against action also leads many people to procrastinate making investments in the first place. Investors procrastinate on making allocation decisions while being overly active in moving funds within a category.
Prospect Theory
Investors sell winners and keep losers. Investors have a strong preference to hold on to stocks that are selling below purchase price, so that they will avoid becoming "losers" and sell stocks that are selling above the purchase price so that they will come out "winners". This pattern is consistent with a regret minimization strategy - that is, an effort to avoid "booking" a loss and feeling regretful. As long a you let the loss "ride" you can pretend it doesn't exist.
Summary
What should investors do to avoid the above mistakes?
Think through one's asset allocation and develop a long term plan
Achieve this allocation in a low cost manner, avoid paying fees to people and companies who do not truly add value
Invest on a regular basis (based on the long term plan)
Account for taxes while making investment decisions
Consider annuities as retirement draws near
This post is a summary of a chapter from the book - Judgment in managerial decision making by Max Bazerman and Don Moore