3 Common Investing Mistakes and How to Avoid Them
3 Common Investing Mistakes and How to Avoid Them
By: Stacey Nickens
We all know the old truism, “Learn from your mistakes.” However, learning from your mistakes is not as easy as it sounds. Sometimes we are not able to identify the specific mistake that we made. Or we are unsure how to fix or avoid the mistake moving forward. When investing, it’s critical that we learn from our mistakes in order to improve our investment outcomes. Accordingly, we will review some common mistakes that investors make as well as how you can shift your mindset to avoid these mistakes.
Mistake 1: Developing an investment process through trial and error. Trial and error can be a highly effective learning process. However, trial and error works best when you have stable cues and stable outcomes. For example, consider a stove. When stoves are hot, they often turn red. This is a stable cue. It will not change. Then, when you touch a red stove, you burn your hand. Again, this is a stable outcome. You can thus effectively learn to not touch hot stoves through trial and error. Once you touch a hot stove and burn your hand, you learn to not touch hot stoves.
When investing, you do not usually have stable cues and stable outcomes. Perhaps you invest in a few different equities and don’t achieve your desired level of growth. Can you now conclude that your trial taught you that these equities were all bad investments? That seems like a stretch given that a number of factors could have contributed to your account’s low growth.
Investors often rely on trial and error when they have little conviction in their investing process. To avoid relying on trial and error, you need to thus ground yourself in your investment philosophy. I encourage you to write down an investment philosophy statement. What do you believe about investing? What evidence do you have to support those beliefs? Why is your approach better than other approaches? Writing out this statement can help you develop conviction in your investing process such that you rely less on trial and error.
Mistake 2: Consuming too much investment information. With so much information available, it can be tempting to constantly consume information about the stock market. It may feel like the more you know, the better your investments will be. However, Herbert Simon, a Nobel Prize Winner in decision theory, once said, “What information consumes is rather obvious: it consumes the attention of its recipients. Hence a wealth of information creates a poverty of attention.”
Simon was pointing out that too much information can be distracting and unproductive. Indeed, scientists once studied individuals who bet on horse races. As the horse race betters consumed more information, the horse race betters became more confident. However, after consuming a certain level of information, the horse race betters did not become more accurate. As a result, the horse race betters started to make riskier bets without achieving better results.
The same can occur when investing. To avoid this, use your investment policy statement to decide what investment information is most important to you. Set up a market dashboard to focus exclusively on these data points, and try to avoid wasting unnecessary energy on extraneous data.
Mistake 3: Relying on the plausible but not the probable. Human brains are designed to consume as little energy as possible. Our brains want to find answers easily and quickly. As a result, our brains can sometimes lead us astray. Consider a study where participants were told about a woman. This woman was an English major in college who cared about the environment. The study participants were then asked to guess the woman’s current profession. The participants were given the following options: an engineer, a librarian, or a librarian who belonged to the Sierra Club. Most participants selected the final option because it fit within the narrative of the woman’s life. It felt plausible that a woman who studied English and cared about the environment would later become a librarian who belonged to the Sierra Club. However, in reality, there are far more engineers than librarians, and there are far more librarians than librarians who also belong to the Sierra Club. Based on probability, the woman is likely an engineer. Yet participants fell for a good story instead of considering facts and probability.
We all make similar mistakes when investing. Often times, our brains will get trapped by different biases, such as groupthink, confirmation bias, and belief bias. Groupthink is humanity’s tendency to believe what a leader or a majority of the group believes. Belief bias is holding beliefs that are based more in opinion than fact, and confirmation bias is our tendency to seek out information that supports our already-held beliefs.
To avoid some of these traps when investing, be skeptical. Always challenge the major facts supporting your beliefs in order to avoid biases. Once you’ve decided why you will invest in a specific way, you can ask a friend to challenge you in a faux debate. Doing so will force you to think through the holes and biases in your thinking. After considering contrarian perspectives, you can then decide on your final steps. Afterwards, document your decision-making process. If you dislike the outcomes later, you can review your process to see what might not have worked.
