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Big Investing Mistakes

Human behaviour carries a lot of baggage. Almost all of our evolution as a species has taken place living in caves in small groups, hunting and foraging for food in the wild. So we’ve developed various forms of behaviour to help us to deal with that sort of situation.

Skip forward a few thousand years and we’re living in sprawling cities, driving fast cars and holidaying on the other side of the world. No wonder we have difficulty adapting!

Cavemen

Many of the most ingrained ‘caveman’ character instincts derive from a sense of self-importance or ego. An idea that comes from us, or from our experience, is given extra significance simply because we’ve produced it.

There’s nothing necessarily wrong with that — after all an idea that has its origin inside us will naturally have a special significance. Things go wrong, however, when that develops into an undeserved superiority over other ideas.

One of the places that this type of thing is most obvious and most inappropriate is the share market. Because it’s a market populated with thousands of investors with millions of opinions, there’s even less reason than usual to award a special significance to our own ideas.

These behavioural traits are incredibly difficult to shake off, but if you want to be successful as an investor, then you have to try!

Overconfidence

One of the biggest mistakes that people make in modern life is to be overconfident. Leading US investor Whitney Tilson makes the following points:

* 82% of people say they are in the top 30% of safe drivers;

* 68% of lawyers in civil cases believe that their side will prevail;

* 81% of new business owners think their business has at least a 70% chance of success, but only 39% think any business like theirs would be likely to succeed;

* Mutual fund managers, analysts, and business executives at a conference were asked to write down how much money they would have at retirement and how much the average person in the room would have. The average figures were $5 million and $2.6 million, respectively. The professor who asked the question said that, regardless of the audience, the ratio is always approximately 2:1.

Overconfidence presumably creeps in because human propagation has tended to be better served by action over inaction. It might be dangerous to go and hunt a mammoth, but it will pull the ladies and feed their offspring better than sitting in the corner of a cave going hungry.

Eggs In A Basket

In investing, overconfidence leads to people placing too much reliance on their own investment choices.

Unfortunately, things can and will go wrong with investments — even if you do everything right. The world moves forward with a certain unpredictable randomness and you can never know for sure what’s around the corner.

Happily, overconfidence has a straightforward solution — don’t put all your eggs in one basket. Few people have ever regretted having a couple ‘too many’ shares in their portfolio, but plenty have regretted having too few.

In share market terms, the most ‘diversified’ you can get is a market-weighted index tracker which, if it does its job properly, entirely removes the risks of individual selection decisions.

Falling In Love

Not too far removed from overconfidence is ‘commitment tendency’.

The theory goes that once we’ve made an emotional commitment to something, then we tend to hang on to it to the exclusion of anything else. No doubt this sort of thing helped cavemen to maintain important relationships, but it’s a disaster when applied to investment. As the saying goes ‘never fall in love with a share because it won’t love you back’.

When investors generate an investment idea and follow it up with hours of research and large doses of money, they have a tendency to build up an emotional commitment to that investment. If things then start to go wrong, investors will often go into denial — but there are lots of crocodiles in denial!!

Probably the best way to deal with this problem is to recognise that the time and effort you have put into researching an investment does not need to be rewarded by that investment going up. Instead, it can be rewarded by getting things “as right as possible”. That means getting out of something if it no longer fits your reasons for investing as much as it means getting in if it does.

Framing

Another mistake investors make is to allow their thinking to be ‘framed’ by their own limited experience.

You go out and buy the new shoelace-o-matic, play with it for a week and become convinced that it’s the next big thing. Meanwhile, the other 99.9% of the population is happy to carry on tying their shoelaces by hand.

Presumably this sort of behaviour has helped humans take their experiences and apply it to new situations. That would probably work fine in a reasonably stable environment, but the stock market is anything but stable. Instead, you have thousands of ideas being applied to thousands of situations, many of which are far beyond anyone’s individual frame of reference.

There probably isn’t much of a cure for framing, other than to try to be aware of it. At least that way you can feel it coming on and resolve to do more wide-ranging research.

More Mistakes

We’ve made plenty of mistakes as investors and these are some of the causes we bump into most often. The key however is to learn from them, and keep plugging away.

Humans may have some embarrassing behavioural traits, but we’re supremely adaptable!

In our free email, Take Stock, we’ll regularly be trying to learn from our mistakes, and from the mistakes of others. We’ll also take a light-hearted but informative look at the companies and economies moving the share market.

Take Stock is an integral part of The Motley Fool’s Investor Revolution. If you’d like to join us on our campaign to empower individual investors, click here to enter your email address.

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