The 10 Mistakes Investors Most Commonly Make

×
Stop signAll investors make mistakes. Otherwise, we'd all be millionaires. The trick is figuring out what our investing mistakes are -- and then trying to avoid them.

Meir Statman, one of the nation's leading experts in behavioral finance (the study of why people do irrational things with their money), has written a new book on the topic. In What Investors Really Want, published in October by McGraw-Hill, Statman goes a long way toward helping investors understand that many of their mistakes are caused by their own deep-seated emotions rather than, say, a company's unexpectedly poor earnings.

In an interview with DailyFinance, Statman, a professor of finance at Santa Clara University in California, shared his top 10 errors that trip up average investors:

Meir Statman: What Investors Really Want1. Hindsight error. "One of the most pernicious mistakes," Statman says. Because you can see the past clearly, you think you have a similar ability to tell the future. Hindsight error is common at the moment, Statman says, because many people are convinced they saw the crash coming in 2007. In reality, they may have thought a crash was possible, but they also thought the market might continue to zoom upward. Now, investors are convinced they actually saw the problem in 2007 but just didn't act on it. So, they believe wrongly that they can act correctly today. They think they know to sell at the precise moment the market is high and buy when the market is low. Based on their hindsight of 2007, portfolio diversification doesn't protect you from losses. But market timing rarely works, Statman says.

2. Unrealistic optimism. This is loosely related to overconfidence. Psychological studies have shown that when you ask people if they think they have the ability to pick stocks that will have above-average returns, men tend to say yes more often than women. "It's not because men are so smart. It's because men are unrealistically optimistic about their abilities," Statman says. This quality is great for job interviews, where you need to stand out from a crowd, but lousy for investing. "When you are unreasonably optimistic in the stock market, you are just readying yourself for an accident," he says.

3. Extrapolation errors. People expect that trends that existed in the recent past will continue in the future. For example, the fact that gold has gone up for the last 10 years has led many to believe it will always go up. But a study of a longer period -- going back to 1971 when President Richard Nixon ended the gold standard -- shows that gold hit a high of $850 an ounce in 1980 but was selling for $345 as long as 10 years later.

4. Framing errors. Often, Statman says, investing is like a game of tennis. People tend to see themselves hitting a ball against a wall, which seems easy. But that's the wrong frame. Investing is really like playing against another player -- when the other player is Warren Buffett or Goldman Sachs. Investors make framing errors when they see a CEO on TV talking up his stock. If it sounds good and you buy that stock, that's a framing error. Instead, you should be asking yourself: "Who else is watching this program, and what do I know that is uniquely mine?" "The answer is nothing," Statman says.

5. Availability errors. This refers to what information is available in your memory. Investors are often lulled into this error by investment companies. When you see an advertisement for a fund, it's almost invariably for one that has a four- or five-star rating from Morningstar. That way, the one- and two-star funds, with lackluster results, aren't available in your memory. "You say to yourself that there's a 90% chance I will be a winner," Statman says. Instead, look at results of entire fund families -- including the losers, not just the winning funds for a particular period, he says.

6. Confirmation errors. Investors tend to look for information that confirms their hypothesis, but they disregard evidence that contradicts it. Gold bugs, for example, constantly remind us that gold is a good hedge against inflation and a declining dollar. But when confronted with the evidence that gold actually fell price for an entire decade, they dismiss that as a different era because Ronald Reagan changed the rules of the investing game, and that problem won't be repeated.

7. Illusion of control. This is a sense investors have that they can make the market go up or down. It's like gamblers blowing on their dice before rolling. "These investors think they're riding the tiger, when in fact they're holding the tiger by the tail," Statman says. If you think you have a trick that can get the market to go your way, you better think twice: This is the illusion of control. "When you realize the market is actually a wild beast that can devour you, you try to put it in a cage," he says. A much safer approach.

8. Anger. This is an emotion we all know: It leads to things like road rage. In investing, you try to get even with the market. You do such things as double down or even sell all your stocks impulsively. "If you feel angry, it's better to wait 10 days before buying or selling, or you'll regret it later on," Statman says,

9. Fear. The other side of exuberance. When you're afraid, everything looks like a threat, and when you're exuberant, everything looks like an opportunity. Lots of investors are still afraid because of the market crash two years ago. They're sitting on the sidelines in cash earning no return or investing in things like Treasury bills, which aren't much of a bargain. "Risk and return go together," Statman says. "So, if you think the market is risky today, then you should also think the market has a good potential for high returns."

10. Affinity of groups. Also known as herding. You hear from your pediatrician that he's buying gold, so you think you should, too. But what do these people really know? What is the analysis based on? Statman notes that some herds are worth joining and some aren't. Many investors follow Warren Buffett's investment decisions and buy similar stocks. Since Buffett is usually a winner, perhaps that's a herd worth joining. But buying Internet stocks in 1999 or houses in 2005 based on what everyone else was doing was a horrible mistake.

Statman makes no grand conclusions in his book, but he does point out repeatedly that the average investor can rarely beat the market. Therefore, he recommends small investors put their money in index funds that provide average, if not spectacular returns -- and not catastrophic losses

"But if you like the pizazz of investing," he says, you might take a shot on individual stocks. Just be careful.

Increase your money and finance knowledge from home

Portfolio Basics

What are stocks? Learn how to start investing.

View Course »

Professional Vs Do it Yourself Investing

Should you get advice or DYI?

View Course »

Add a Comment

*0 / 3000 Character Maximum

35 Comments

Filter by:
hjtepak

never invest in someting that U do not control... buy land.... reap the benefits of coal, oil, gas and other commodities.. also invest in junk...scrap... metal and plastic... see www.enviropak.ws.... now that is an investment!!

December 11 2010 at 12:29 AM Report abuse rate up rate down Reply
Paul

Also remember that just because a stock goes down in value it's not a loss unless you sell it right then. You still have the shares. One of the worst things people did when the market bottomed out was to sell their shares. Why? Why assume it was some sort of permanent condition? When the market was up that wasn't a permanent condition either. When the stock market was on sale for the past year we bought like crazy. Alot of people dumped blue chip stocks that, at that moment in time, had very low values. Well, ok then, we'll take them.

December 10 2010 at 5:32 AM Report abuse +1 rate up rate down Reply
walters474

It's a hourse race, but the chances of winning are better.

December 09 2010 at 11:15 AM Report abuse rate up rate down Reply
janealice

The biggest mistake I made came from my own ignorance. I called Fidelity to tell them to sell everything when I knew the market was going to crash after the dot tech bubble. The man I spoke with led me to believe that selling my funds would "destablize the fund." He made me feel responsible for what would be the losses of many investors. MY $200,000. I naively believed him and lost my life savings. I had been pretty savvy until then, doubling my $100,000. I didn't trust myself to sell my holdings on the computer, as it was new to me. Instead, I trusted their agent. I live on $1,036 social security today which covers Medicare, AARP supplement and my car insurance and a phone. I am dependent on my family for food and shelter, and I am mad as hell. Can't find work at 68. Please learn from me.

December 09 2010 at 9:36 AM Report abuse +2 rate up rate down Reply
1 reply to janealice's comment
purplemountaing

janealice, Thank you for sharing your story. That is difficult and I can say I have had the same experience. I lost big time in 2000 and lost a 40 yr. friendship from money investing and so forth. Listening to yourself is the way to go because at least if you screw up...you blame yourself and can forgive yourself. I don't listen to Fidelity anymore either or my financial advisor. They listen to me! I am the captain of my ship and it has actually caused me to be happier and not a victim. It did cost me several hundred thousand dollars to learn this. Also, you never go broke taking a profit either.

December 09 2010 at 11:52 AM Report abuse rate up rate down Reply
pavlovscat8045

So, according to this article, no one should ever invest in anything because you just can't win no matter what you do.

December 09 2010 at 5:34 AM Report abuse rate up rate down Reply
commodr

A big one not on the list is risk management... never invest with more than you can afford to lose.

December 09 2010 at 4:26 AM Report abuse +1 rate up rate down Reply
hockboy41

Mr. Wallace, This is a poor man's treatise on behavioral economics. At the very least admit it, if not upgrade your lexicon. Thanks, Anonymous University of Chicago

December 09 2010 at 2:14 AM Report abuse rate up rate down Reply
oliver0160

I recently turned 5,000 dollars into 25,000 dollars trading options in four months for a contest with friends (I won 10,000 dollars). In the year and a half before that I traded a 30,000 dollar account into over 400k. I agree and disagree with people who call the market a casino. The market is a casino with a house that has no interest in whether you win or lose. Because of that, you're playing people. So if you play the odds in your favor as a trader, cut your losses when they're losses, you can come out on top. I'm right on a good month 5 to 6 times out of 10, 60 to 70% of the time I'm right 3 out of 10 transactions. I've watched a 15,000 dollar win, turn into 2,000 dollar loss because i got greedy.

December 09 2010 at 1:43 AM Report abuse rate up rate down Reply
EASY8363

The best investment I have found is to invest in your family...especially in your children. What we have now is economic slavery. The man doesn't want us to progress.We elect them and they tell us what to do.

December 09 2010 at 1:11 AM Report abuse rate up rate down Reply
tianyi7886

Anyone still actively investing need to tread the lightly. Trading/investing is a zero sum game. For every trade you make, there is a counterparty, so for every dollar you make, someone loses a dollar. Looking at investment bank and hedge fund profits, it's pretty clear that the losers in the financial industry are not the mega institutions, it is the retail investor. When Goldman, JP, and Morgan Stanley all posted those amazing no loss quarters in 2009 and earlier in 2010, it's pretty good evidence that the game is rigged against the retail. Remember that investing/trading is zero sum, so when GS, JPM, MS, C, BAC, etc. all have profitable quarters in their trading desks, it simply means the money they made came from the pocket of retail investors.

December 09 2010 at 12:40 AM Report abuse rate up rate down Reply