There are a number of Cognitive biases that lead investors to make the same mistakes:
- Confirmation bias: A tendency to seek out information that confirms one’s preexisting beliefs or hypotheses.
- Anchoring: A tendency to give too much weight to the first piece of information encountered (the “anchor”) when making decisions.
- Herding: A tendency to follow the crowd, even if it means making sub-optimal decisions.
- Recency Bias: A tendency to overweight recent information when making investment decisions, while underweighting or ignoring older data points.
- Overconfidence Bias: A belief that one has a better understanding of the market or a particular security than is actually the case, leading to suboptimal investment decision
All investors make mistakes. Good investors learn from their own mistakes and great investors also learn from others’ mistakes. Here is your opportunity to do so.
11. Not Properly Diversifying Their Portfolio
This means not investing in a variety of different asset classes in order to mitigate risk. For example, if someone only invests in a few stocks, they are not diversified.
How To Properly Diversify Your Portfolio
- Make sure that you’re diversified across different asset classes. This means having a mix of stocks, bonds, and cash in your portfolio.
- You need to make sure that you’re diversified within each asset class. For example, if you’re investing in stocks, you should have a mix of large cap and small cap stocks.
- Make sure that your portfolios are properly allocated. This means having the right mix of growth and income-producing investments.
A well-diversified portfolio will protect an investor from the losses that can occur when markets decline.
10. Not Having A Long-Term Investment Horizon Or Chasing Short Term Gains
This refers to the time frame in which you plan on holding an investment. If you do not have a long-term investment horizon, you may be more likely to sell an investment when it experiences short-term volatility. Making decisions based on the potential for quick profits instead of investing with a long-term perspective. For example, buying shares of a company that is about to release a new product might be considered chasing short-term gains. Buying a stock because you are hoping for good quarterly results in the coming weeks or months fits the description as well.
How To Build A Long-Term Investment Horizon?
It is important to have a long-term investment horizon when making financial decisions because it allows you to weather temporary market fluctuations and take advantage of compounding returns over time. A long-term investment horizon also gives you the flexibility to invest in a variety of assets, including those that may be considered higher risk but have the potential for higher rewards.
There are a few things you can do to help ensure you have a long-term investment horizon. First, make sure your financial goals are realistic and achievable. Second, work with a financial advisor to develop an investment plan that is tailored to your unique needs and objectives. Finally, be disciplined in your approach to investing, particularly when it comes to buying and selling assets.
9. Not Sticking To Their Investment Plan
This could happen if you make changes to your portfolio without considering how it will affect your overall goals. For example, if you sell a stock simply because it has gone down in value, this would be considered not sticking to your investment plan.
How To Stick To Your Investment Plan
The most important thing when it comes to sticking to your investment plan is to have a well-thought-out investment plan to begin with. Your investment plan should be based on your specific financial goals, risk tolerance, and time horizon. Once you have a clear investment plan in place, the best way to stick to it is to automate your investments as much as possible. This could involve setting up automatic transfers from your checking account into your investment account or using dollar-cost averaging to systematically invest a fixed amount of money into your chosen investments on a regular basis.
8. Making Emotional Decisions
This happens when someone allows their emotions (such as fear or greed) to influence their investing decision making process. An example of an emotional decision would be selling all of your investments after experiencing heavy losses in the stock market crash of 2008. Benjamin Graham has a whole chapter in The Intelligent Investor on the bipolar tendencies of Mr. Market. Don’t be Mr. Market.
How To Stay Rational When Investing
Remember that investing is a probabilities game. That is, don’t get too wrapped up in any one investment; focus instead on the odds that it will be successful.
It can also be helpful to have some sort of system or process in place to keep emotions in check. For example, some investors impose limits on how much they’re willing to lose on any one investment. Be mindful that your investment thesis, no matter how sophisticated it can be, might be partly – or completely – wrong.
7. Reacting To News Events
Many investors make the mistake of reacting to news events instead of conducting their own research before making an investment decision. An example of this would be buying shares of a company that has been in the news recently without first researching the company. Another issue might be buying on good news or selling on bad news, which would be the opposite of what is recommended.
How To Avoid Reacting To News Events
Or even better, do the opposite. Nathan Rothschild famously said: “the time to buy is when there’s blood in the streets” and Buffet was quoted saying “Be fearful when others are greedy, and greedy when others are fearful”. Adopting a contrarian mindset goes a long way here.
6. Failing To Rebalance Their Portfolio
This means not selling assets that have increased in value and buying more of assets that have decreased in value, which can lead to an imbalance in your portfolio. For example, if you have a portfolio that is 60% stocks and 40% bonds, but the stock market increases by 10%, your portfolio is now 66% stocks and 34% bonds.
Rebalancing Your Portfolio
To rebalance, you would sell some of your stocks and buy more bonds to get back to your original asset allocation.
5. Paying Too Much In Fees And Commissions
Paying too much in fees and commissions – This happens when an investor pays excessive fees or commissions to a financial advisor or broker. Fees and commissions can eat into investment returns over time, so it’s important to be aware of how much you are paying.
How To Avoid Paying Too Much In Fees And Commissions
Heavy portfolio activity is the enemy of saving on commissions. Fred Schwed wrote an interesting book on this topic called “Where are the customer’s yachts?”
Here, it would be helpful to shop around and compare fees and commissions. There are even a handful of free options out there. Be investigative: ask questions and understand what you are paying for.
4. Selling Winners Too Soon And Hanging Onto Losers
This happens when investors sell their investments that have increased in value too quickly, but hold onto their losing investments for too long hoping they will rebound eventually. Selling winners too soon can result in realized capital gains taxes which could have been avoided if the investment was held for longer.
This can also have the second-hand effect of causing anchoring and keeping the investor out of a good compounder stock. On the other hand, holding onto losers to avoid realizing losses for too long can cause investors to lose even more money as their losses continue to compound over time.
How To Avoid The Disposition Effect
The disposition effect can be avoided by understanding its underlying cause, which is the cognitive bias known as myopic loss aversion. This bias leads investors to focus on short-term losses and neglect long-term gains.
To avoid the disposition effect, investors should think long-term and focus on their overall investment goal. They should also diversify their portfolio to mitigate losses and take advantage of market opportunities.
3. Failing To Take Into Account Taxes
As one of the only two sure things in life, taxes cannot be avoided. Not factoring in the taxes you will have to pay on your investment gains would have a big impact on how much money you ultimately make on an investment.
How To Optimize Investments For Taxes
Some taxes on investments are avoidable, while others depend on an investor’s circumstances and cannot be avoided. Many investors are able to reduce their taxes by investing in specific types of accounts, such as a RRSP or TFSA.
Some experts recommend that investors try to keep their tax liabilities as low as possible by investing in tax-advantaged accounts and strategies.
In some cases, it might be helpful to work with a tax professional to minimize your tax liability.
2. Investing in too many things
Although diversifying to some extent is key, over diversifying is probably a worse problem for investors these days. Trying to spread your money too thin by investing in too many different things can often lead to sub-par results overall. Fund managers doing this are often referred to as closet indexers. They bring no additional value than an ETF would, but they charge slightly higher fees. The customers end up way worse once these fees are compounded over many years.
How Many Stocks You Should Hold
Diversifying into more than 10 stocks protects one against his own incompetency. But having more than 25 different holdings is probably too much. Think about it: how good is your 26th best idea, really?
1. Investing In Something They Do Not Understand
A person may invest in a company or stock without doing any research on it or without truly understanding what its business model or economics are. This can lead to them permanently losing money
Do Your Own Research
The recommendation is easy, but applying it requires force of character: educate yourself about what you are investing in.
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