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Mental Mistakes

YOU MAY UNDERSTAND the nuts and bolts of building a globally diversified portfolio. But that knowledge, by itself, won’t ensure success.

Think back to late 2008 and early 2009, when the stock market offered investors a once-in-a-generation buying opportunity. Did you take advantage—or did you simply sit tight or perhaps even panic and sell? We like to believe we’re clearheaded and rational. But when it comes to managing money, often we’re all too human. Here are three common mental mistakes:

Excessive self-confidence. We tend to attribute our investment winners to our own brilliance, while blaming our losers on others. In fact, during rising stock markets, our self-confidence can balloon, leading us to take more risk and trade excessively. But all that trading is costly, while the greater risk can come back to haunt us when the market next turns down.

Extrapolation. The stock market’s daily performance may be unpredictable, but we often think we see patterns. For instance, we tend to extrapolate returns, prompting us to assume that a rising market will keep on rising—and that tumbling shares will continue to fall. Our tendency to be overly influenced by the events of recent months and years is known as recency bias.

Loss aversion. Most of us are deeply reluctant to sell stocks at a loss, because it means admitting we made a mistake and giving up all chance of recouping the loss. The desire to “get even, then get out” can be a helpful trait during broad market declines, because it may stop us from selling at the worst possible time. But our reluctance to sell losers isn’t so helpful with individual investments. If we own a badly run mutual fund or a stock that’s in financial trouble, we might be better off selling, taking the tax loss and reinvesting the money elsewhere.

Our Humble Opinion: Investing is sufficiently simple that most folks should be able to learn the basics. But just because investing is simple doesn’t mean it’s easy. Saving for retirement, college and other goals is so important that you need to minimize self-inflicted investment wounds. Find it hard to keep your emotions in check? That’s a key reason to hire a financial advisor—though, if you don’t pick carefully, that also can be risky.

Next: The Seasoned Investor

Previous: Active Fund Managers

Blogs: All Too Human and Not So Dumb

Related: Coping With Market Declines

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