The late value investor Benjamin Graham once said: “The investor’s chief problem – and even his worst enemy – is likely to be himself.”
Mr. Graham knew a thing or two about investing. His most famous disciple, Warren Buffett, was so influenced by Mr. Graham that he named his son, Howard Graham Buffett, after his mentor.
We can earn a lot from Mr. Graham, too, particularly his comment about how investors sabotage themselves. Most of us have engaged in self-defeating behaviours when it comes to investing or managing money. In fact, I would argue that humans are hardwired to be terrible investors.
To achieve success, we often need to do the opposite of what our instincts are telling us.
That’s easier said than done. After all, our brains evolved over millions of years when our principal goals were to find food and avoid large animals with very sharp teeth. Investing and money are modern problems for which our ancient brains aren’t particularly well-equipped.
Here’s a list of common investing mistakes and steps we can take to fix them.
When the stock market is plunging, investors experience a physiological reaction similar to when they are facing mortal danger. The fear response is so powerful that, just as our ancestors ran away from hungry predators, investors flee the stock market by selling. In the short term they feel better, but in the long run they’re worse off because they lock in their losses near the market’s lows and miss out on the subsequent rebound.
The opposite happens when stocks are soaring. Seeing prices tick higher and higher, our brains expect the pattern to continue. The euphoria – physiologically similar to a person taking a drug such as cocaine – prompts us to buy more near market tops, even though it’s more profitable to deploy cash during market slumps. You can see the “sell low, buy high” phenomenon in mutual fund data; surveys show that the vast majority of fund investors make far less than the returns of the funds themselves.
Trading too much
From a young age we’re told that, if we work hard enough, we can achieve anything. Problem is, the harder you try as an investor – by buying and selling frequently or chasing hot tips – the worse off you’re likely to be. Trading excessively increases commissions, drives up taxes and causes investors to miss out on gains they could have achieved by simply buying and holding high-quality companies or index funds. Some people can make a living at trading; most are better off building a diversified portfolio and leaving it alone.
Swinging for the fences
Many investors take on more risk than they should. Why? Because they’re looking for instant gratification. They want to hit the jackpot now instead of patiently saving and investing over many years, which is the surest way to build wealth. By chasing big returns, they end up poorer when their high-risk bets blow up.
Trying to look rich
Some people use cars, homes and jewellery to assert their status in the social hierarchy, but it can be a recipe for financial trouble when the debts incurred to finance their lavish lifestyles become too much to manage. If you want to be wealthy – and not just look wealthy – you need to save and invest some of your cash, not blow it on material goods with ephemeral benefits.
So, how can you overcome the powerful – and often harmful – emotions that influence many investing and spending decisions?
One solution is to set up a systematic saving and investing plan so that money is automatically withdrawn from your bank account every month and allocated to a low-cost index fund. Making investing automatic will prevent you from selling in a panic, or going all-in when a friend presents you with a “can’t-miss” investing opportunity.
For investors who own individual stocks, keeping a shopping list of high-quality companies – and the prices at which you would like to buy them – can turn a scary market downturn into an opportunity to pick up stocks on the cheap. Bear markets never last forever; staying focused on the long term is the key to achieving investment success.
Your brain is an amazing and complex organ, but when it comes to investing, it can lead you astray if you aren’t careful.