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investor clinic

In my column last week, I discussed "yield on cost" and showed why investors shouldn't use this measure to justify hanging on to a stock.

Today, I want to explore a handful of other common mental errors that investors make. Some of these errors are based on emotion. Others are based on flawed math. By recognizing these mistakes, you'll make yourself a better investor.

Trying to break even

You buy a stock for $50 and it falls to $45 – and stays there. "I'll just wait until it gets back to $50 and then I'll sell it," you tell yourself. The technical term for this behaviour is "anchoring," and it's a problem because the psychological desire to break even could cause you to hang on when there may be better opportunities elsewhere. What you paid for the stock is actually irrelevant; the only thing that matters now are the future prospects for the investment. If the outlook is lousy, you might be better off taking your lumps and moving on. If you still like the company's prospects, then holding on may indeed make sense.

Focusing on your cost base

This is a closely related concept. You buy a stock for $50, and it rises to $60. Because you have an unrealized capital gain or "cushion" of $10, you feel good about holding on to the stock because a lot has to go wrong before you lose all of your paper profit. But as with the first example, the original price you paid for the stock is irrelevant. It's history. What matters is where the stock goes from its current price of $60, not whether it stays above your original purchase price.

Recency bias

This is one of the most common traps. You see a stock chart that goes straight up, and you assume the stock will keep rising. Conversely, you see a chart that goes down and assume the losses will continue. Humans are wired to expect things that happened in the past to happen again, but investing is not that simple. In fact, mutual fund studies indicate that many investors underperform the market because they tend to buy near the top and sell near the bottom in the mistaken belief that the recent trend will continue, which it often doesn't.

Mental accounting

Some investors compartmentalize their money based on its source or its purpose. For example, they have one account with conservative retirement assets and another with "play money" that they are prepared to gamble on risky stocks. Their RRSP refund might go into a third pile to splurge on a vacation or big-screen TV. Money that arrives unexpectedly in a big lump sum often goes out the door just as quickly: I once met a guy at a Blue Jays game who told me the first thing he would do if he won the 50-50 draw would be to order a limousine to take him home. (He didn't win the draw so I think he walked.) When we use mental accounting, we ignore the fact that a dollar is a dollar; where the money came from shouldn't influence how we spend it.

Refusing to put dividend stocks inside an RRSP

I've lost count of the number of people who have told me they don't put dividend stocks inside their RRSP "because I would have to pay tax at my full rate when I eventually pull the dividends out, whereas outside the RRSP I get the dividend tax credit." This fallacy arises because people don't understand the difference between pre-tax dollars (inside an RRSP) and after-tax dollars (outside an RRSP). I've discussed this in detail in a previous column.