Last Updated Jan 19, 2010 12:29 PM EST
In his newly revised book, Why Smart People Make Big Money Mistakes and How to Correct Them, co-author Gary Belsky says irrational behavior often leads us to make dumb and costly financial decisions. In this excerpt, Belsky reveals the investing secrets that will help you avoid such goofs.
We all commit financial follies that cost us hundreds or thousands of dollars each year. Worse, we’re often blissfully ignorant of the causes of our monetary missteps and clueless about how to correct them. But by knowing these five big investing mistakes, you can change your behavior to put more money in your pocket.
1. Letting Losses Hurt More Than Gains Please You
People generally are “loss averse.” The pain felt from losing $100 is much greater than the pleasure from gaining the same amount. That’s why people behave inconsistently when it comes to taking investment risks. You might act conservatively to protect gains (by selling your winners to guarantee the profits) but act recklessly to avoid losses (by holding onto losers, hoping they’ll bounce back). Loss aversion causes some investors to sell all their holdings during periods of market turmoil, but trying to time the market doesn’t work in the long run.
2. Placing Too Much Emphasis on Unusual Events
Many people still recall the stock market crash of 2008 with anxiety, forgetting that stocks have offered the most consistent investment gains over time. As MoneyWatch blogger Nathan Hale has written, investors often pour money into mutual funds that performed well recently on the mistaken belief that the funds’ success is the result of something other than dumb luck.
3. Being Paralyzed by Investment Choices
You can’t let yourself get so overwhelmed by a surfeit of options that you penalize your finances through inaction. Some people won’t move money out of ultra-conservative, low-yielding retirement funds because they can’t bear having to select a better alternative. So limit your choices. Find “trusted screeners” whose judgment you admire to pare down your choices or even make them for you.
4. Ignoring the ‘Small’ Numbers
People have a tendency to ignore what they think are insignificant numbers, such as mutual fund expenses. But doing so can have a deleterious effect of surprising magnitude on your investment returns over time. On a $10,000 investment, an expense ratio of 0.5 percent might cost you about $180 over three years, but a 1.5 percent expense tab could nick you by $500 or so. Over 15 years, a low-expense fund might eat up less than 7 percent of your potential investment return, while a high-expense fund could devour almost 20 percent.
5. Failing to Understand the Odds against Beating the Market
Most investors will fare best by sticking primarily with index funds mirroring the averages. You won’t just keep up with the typical investor this way; you’ll likely do better than all those brave souls who think they can beat the law of averages. High transaction and management expenses, faulty psychology, and the law of averages often burden actively managed portfolios. Index funds take much of the emotion out of investing. And the most successful investors are the ones who don’t let emotions affect their decisions.
From Why Smart People Make Big Money Mistakes and How to Correct Them by Gary Belsky & Thomas Gilovich. Copyright 1999, 2009, by Gary Belsky and Thomas Gilovich. Reprinted by permission of Simon & Schuster, Inc.
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