When it comes to managing our retirement funds, many of us suffer from perpetual insanity.
That's not to say we're crazy, although some investors may be when they take stock tips from television gurus or from brothers-in-law.
I'm referring to Albert Einstein's definition of insanity: "Doing the same thing over and over again and expecting different results."
This one observation has spawned a relatively new branch of social science called behavioral economics.
By looking at errors that we make consistently -- particularly when they concern money -- we can discover what we're doing wrong. Self-discovery can lead to insight and hopefully, change.
There are three worthwhile reads on behavioral economics that I recommend now to gain some traction on behavioral money errors.
* Richard Thaler's Misbehaving: The Making of Behavioral Economics (Norton, 2015), is a romp through the evolution of this useful branch of economics as told by one of the academic world's leading proponents.
Although Thaler's book is more memoir than advice oriented, it's a joy to read and embrace. He walks you through how he discovered some of the basic tenants of behavioral economics with humor and breezy storytelling.
* Peter Mallouk's The Five Mistakes Every Investor Makes and How to Avoid Them (Wiley, 2014), is much more hands on and brief, showing you what you may be doing wrong and how to correct bad investment behavior.
Mallouk, a certified financial planner, goes full throttle in attacking market timing, overconfidence and other mistakes. It's a quick read that cuts right to the chase.
*Schlomo Benartzi and Roger Lewin's Thinking Smarter: Seven Steps to Your Fulfilling Retirement and Life (Portfolio, 2015), is a much more boiled down action plan to avoid the worst errors.
If you're more confident setting goals and objectives, this book is a good fit. Note than Benartzi was Thaler's research partner and helped create the "Save More Tomorrow" program that sets up employees in automatic 401(k) plans.
The Six Mistakes: How to Avoid Them
Many of us make these errors on a regular basis. I know I have.
But I discovered that once I saw what I was doing wrong, I could correct my behavior and started making money. I began to take a sane approach to investing.
Here are my top six:
* Overconfidence Bias.
We tend to think we're smarter than the market and can beat the odds. That's why lotteries are so popular.
Instead of going to the sure thing or market averages, we consistently bet on single stocks and roll the dice.
Surprisingly, having a mountain of information won't make you a better investor since market prices are often random. Nobody can predict the market consistently.
Most of us are either below- or simply average when it comes to investing. So rather than try to plumb for the next Google (GOOG), buy the entire universe of stocks through a global stock index fund.
* Confirmation Bias.
This is the opposite of science. We look for facts or data that prove our point of view instead of seeing the big picture.
Say you wanted proof that Apple's stock price (AAPL) is rising. If you were smitten with confirmation bias, you'd only select periods in which the stock rose and ignore the others.
You have to look at long periods of time to see how an investment performs. One week, month or year isn't good enough. Look at the ups and downs and long-term returns.
Even if you've looked at 10 years' worth of data, it still won't predict what the stock will do in the future.
Volatility and risk should be more important signals when buying an investment. That way you have a better picture of the downside that doesn't get ignored by your pet theories.
Oh, and read opinions that don't confirm what you think you know. Diversity of thought will help you make better decisions.
* Anchoring.
Some of us are just stuck on numbers for no rational reason. Let's say you want to buy Facebook (FB) stock, but you insist on buying it when it hits $50 a share. Why that price? What happens if it doesn't drop that much?
The same error happens to people who hold onto stocks for too long. Maybe they bought a stock at $50, saw it plummet to $30 and won't sell it until it goes to $50 again, which may never happen.
The best way of avoiding anchoring bias is to have a firm buy/sell discipline. When is the stock a bargain, according to a variety of analysts? When is it overpriced? Do you want to sell or just buy and hold and reap dividends? Make a choice.
* Loss Aversion.
On an emotional level, losses are a form of pain that short circuits our logic.
That stock you bought at $50 is now $30. You won't sell it because it hurts to take a loss, even though you get a small tax write-off for doing so.
The classic proof of this is that experiments have shown that subjects would hold onto a stock that shows a $10/share loss and not feel as bad about losing a $10 bill. In either case, the loss is the same.
Take the loss and move on is a good strategy.
* Mental Accounting.
We put financial decisions into little mental boxes to avoid the pain of a loss.
When it comes to investment, it's the same dilemma. Should we tolerate a loss in our retirement portfolio and not in our short-term savings?
Money is money, no matter where you put it (except for tax-deferred accounts, of course).
We shouldn't create excuses and again look at the big picture over time.
* Recency Bias.
The financial services industry exploits this oversight every day.
"Our mutual fund returned 20% last year."
"Our annuity was the best performer last quarter."
We tend to attach significance to something that happened recently, even if in the greater scheme of things it was a rare event.
Ignore short term results. Get as much return data as you can and compare to benchmarks. You can do this with nearly all mutual/exchange-traded funds, stocks, bonds and commodities.
How do you best avoid these snaffus?
Create an investment policy statement and stick to it. Write down the answers to these questions: 1) how much risk do you want to take? 2) How much should be invested in stocks, bonds and real estate? 3) When do you want to retire or make major purchases? 4) What are your blind spots?
Once you come clean with what you don't know -- and what you want to achieve -- it makes life much easier. A modest plan is better than no plan.
