As you start investing, it helps to carefully avoid being one of the following types of investor.
I really like behavioral finance. Studies into how our behavior influences what happens with our money, and the ways our psychology can lead to poor financial decisions, fascinate me.
Not too long ago, I read an interesting piece in the European Financial Review addressing biases in investing. Part of the article looked at the behaviors of two different types of investor.
As you consider your own investing habits, it helps to look at these descriptions and identify whether or not you are falling into behavioral traps. If you are, it's important that you recognize the problems and overcome them to improve your performance.
You might be too confident in your investing abilities. While you want to be sure enough to start investing, you also want to show enough caution that you don't find yourself over-trading, or taking unseemly risks. Here is what the authors of the European Financial Review piece have to say about overconfident investors:
Research documents that overconfident behaviour is connected to excessive trading and results in poor investment returns. It can also lead to investors failing to appropriately diversify their portfolios.
One of the reasons that you might be overconfident has to do with your portfolio performance. We have a tendency to attribute success to qualities inherent in ourselves, while attributing to failure to outside causes. I felt like an investing genius when my Grow Your Dough portfolio took off. Even now, I'm feeling pretty good because my portfolio continues to perform well.
However, I can't let that go to my head. First of all, most of my investments — in the Grow Your Dough portfolio and elsewhere — are in funds. I'm choosing funds that are fairly diverse, and that follow indexes with solid performances. Plus, the market is doing reasonably well right now.
I can't look at my portfolio and let overconfidence lead me to start stock picking and market timing. Those are two of the main pitfalls that overconfident investors stumble over. Additionally, overconfidence can lead to taking large risks because you are?sure that you are too smart to pick wrong. You might hold onto losers long after you should have sold, sure that a turnaround is coming.
Don't be overconfident, or you could find yourself in serious trouble.
Instead, look for investments that fit into a good strategy, that have long-term staying power, and that have diversity and good value. For beginners, the best option might be to look into low-cost index funds and ETFs.
Status Quo Investing
The other of the types of investor that the article cites is the status quo investor. The authors of the piece reference financial inertia — a topic I've written about in the past. Here is what the European Financial Review has to say about this type of investor:
Status quo bias occurs when investors fail to update their economic conditions despite potential gains from doing so. Instead, they stick to a position, such as holding a stock instead of selling it or otherwise act in a suboptimal manner. People also tend to defer savings for retirement or postpone opening a retirement account. After entering a 401k retirement plan, many employees do not actively manage or monitor their accounts.
Instead of sticking to something that isn't working anymore, the authors suggest that you consider asset allocation that matches with your risk profile. As your risk profile changes (as you approach retirement, for example), you can change your asset allocation to match.
When you are involved with the status quo, you might also be subject to financial inertia. As the authors point out, sticking with the status quo might be accepting the default on your 401(k) plan, or failing to research the cost of fees. I spent years paying more than I should have for a managed fund in my Roth IRA, just because I had opened the account and didn't feel like changing things up.
Since I've moved my Roth IRA to Betterment, though, the performance has improved and the fees have gone down. I'm in a much better place — all because I overcame my financial inertia and stopped adhering to the status quo with my retirement investing.
No matter which of the types of investor you are, it's important for you to recognize your weaknesses and then overcome them. Overconfidence and status quo investing can both cause problems for your portfolio.