Avoiding Big Investing Mistakes
INVESTOR > INVESTMENT
I previously wrote about how the best indicator of investing success is not investment selection, but investor behavior. What you do as the investor is more important than what your investments do.
Assembling a portfolio and asset allocation that will help you reach your goals is indeed important, but training yourself - or getting a trainer - to keep yourself away from big mistakes is more important.
(The data backs this up: you can be invested in the best-performing mutual fund and still lose money.)
As investors, we can sabotage our own financial success through a small number of big investing mistakes, rooted in psychological biases and emotions-based decisions. There's just a ton of evidence that makes we investors think we're better than we are.
So, I have a strong warning for anyone who thinks that they know enough to avoid mistakes: you're not immune.
YOU'RE NOT IMMUNE
In a way, the most dangerous mistake in investing is... thinking you're immune to mistakes in investing!
Unfortunately, inherent in the definition of a psychological bias is that we often have little to no ability to recognize it.
Have you heard the statistic that 90% of drivers think they are above average drivers?
This tendency to rate oneself above average is called illusory superiority, and it manifests itself heavily in investing too. An investing expert once wrote that every time he spoke in public about investing, he asked by show of hands of how many people thought they were above average investors. Consistently, his observation was 75%!
Again, that's not how averages work, is it? :)
I've personally met with several people who sold their investments during the crash of 2007-2009. These were not uneducated people, or those with little investing knowledge. Many came from high-paying professions or were successful businessmen.
I would guess that most of them, before that time (and maybe still now), would've rated themselves as above average investors.
The cold, hard truth is that they knew what should have been done, but in the heat of the moment, emotions, overconfidence, or psychological biases led them to large-scale mistakes.
THE HARDEST THING ABOUT BEING A YOUNG INVESTOR
Perhaps the hardest thing about being a young investor - especially if you started investing for the first time after the 2007-2009 recession - is that you haven't experienced a market crash yet.
Ask any person who experienced the Great Recession, and they'll tell you about how easy it wasn't to watch their portfolio value drop so much in such a short period of time.
As a millennial investor myself, I've found it easy to play off these big investing mistakes as something I'd never do. I think a lot of my peers feel the same way.
However, it's easy to be overconfident in our own ability to gauge how we would act in a situation before we are actually experiencing it.
I've thought a lot about how we, as younger investors, can prepare ourselves for our first large market decline. I'm intrigued about how I will react. How will I feel? Will I worry? Will I panic? I tell myself that I know better and I won't get freaked out, because history shows us that about every other year we'll see a 10% draw-down in the markets. And there have been 11 years that had at least a 20% drop since 1950.
Part of the difficulty in all this is that we younger investors don't have a large portfolio (yet). It's not like someone who has a $500,000 portfolio that drops by $125,000 to $375,000 in a 25% downturn. If my 401(k) goes down from $20,000 to $15,000 in a 25% drop, will I care all that much?
I tell myself that I wouldn't, because I've still got tons of time before retirement and I'm nowhere close to needing that money.
But I don't actually know how I'm going to feel when it actually happens to me! And that's coming from someone who is a financial planner and investment adviser.
It's one thing to read about how to prepare for something. It's another thing to experience it firsthand and feel what it is like.
A SIMPLE TEST
There's no way to actually replace the experience of personally enduring a market correction or economic crash. How you feel and want to react in a situation can contribute greatly to understanding your risk tolerance as an investor.
Even if we can't emulate that experience, perhaps we can try to simulate it?
Here's a simple test you may want to try, just to gauge how you might feel. I double - no, triple-dog dare you to actually try it:
- Add up all of the cash and investment assets you have in every account, and multiply it by 10. Imagine that someone told you that you actually have that amount in your accounts, and how that would feel.
- Think about the cars, computers, phones, and other expensive and/or meaningful possessions you own. Consider which ones would be most painful to have stolen from you, or that you'd miss most.
- Think of three favorite things you love to do in your life. Really, identify the three things you do that make you happiest in your life.
Now this is cruel, but imagine that you woke up one morning and 33% of everything above was taken away from you.
Thirty-three percent of your monetary assets, gone. One-third of your most expensive possessions, gone. Out of the three things you love to do most in your life, you're not allowed to do one of them anymore at all.
All you're told is that it will all be given back at some later date in the future, but you don't know exactly when.
Then ask yourself:
How would you feel in that moment? How would you act? Would you try to get it back? Would you take active measures to protect what you still have left?
It's not a perfect test, but it's a good effort toward forcing yourself through an emotional simulation to help assess your risk tolerance. At the very least, it's something younger investors can do to try to replicate the feeling of watching your life's wealth temporarily vanish.
AVOID YOUR "BIG MISTAKE"
The "one" big mistake for many people is to sell out of their investments in a market crash. While it's the most common "big mistake" to point to and the one I've focused on, there are several other deadly mistakes investors commit:
- For younger investors, it's to procrastinate the decision to start investing, since every year delayed can be tens of thousands of dollars less wealth accumulated on the back-end.
- For others, it's to pump all their money into a business, direct real estate, or any other single investment or asset class.
- For some it is to take too little risk in their investments and lose out on the growth they can't afford to lose.
So how can we avoid or reduce the likelihood of these errors?
For one, there is a vast amount of research showing that the value of a good - and might I say - real financial planner easily outweighs the cost, even if only measured by the value in helping you avoid big mistakes (Don't take it from me, read up on it).
On the other hand, If you're not going to get a "trainer" in the form of a financial planner or at least have an accountability partner, then setting up your own personal Investment Policy Statement (IPS) is the best thing you can do. This is a document you set up for yourself to decide in advance the parameters under which you will make investing decisions, instead of trying to make those choices when in an emotional state.
In his book, The Laws of Wealth: Psychology and the Secret to Investing Success, Dr. Daniel Crosby wisely summarizes:
"Despite the unequivocal truth that investor behavior is a better predictor of wealth creation than fund selection or market timing, no one dreams about not panicking, making regular contributions and maintaining a long-term focus."
Powerful emotions like fear and greed combined with biases like overconfidence and pride are really the biggest obstacles to successful investing. It's these factors that lead to the big mistakes you can't recover from.
Like I've said before, many things in financial success are simple, but not necessarily easy. And that definitely applies to avoiding big investing mistakes.