Stop Sabotaging Your Future: Win the Inner Game of Investing

By A. Andrew Raub

No one intends to shoot themselves in the foot, financially speaking. But I'm sure you can think of someone who has done just that—it might even be you! Perhaps you made an emotional decision to invest in a risky endeavor, held an investment for too long because of sentiment, or let a negative past experience overshadow all sound investment advice. If any of this sounds familiar, you're not alone!

In fact, research in the field of behavioral finance shows that people tend to make investing decisions with their hearts and not with their heads. Consequently, they often sabotage their own best financial interests. According to the mutual fund research firm DALBAR, the average mutual fund in the S&P 500 increased by 12.22 percent annually from 1984 to 2005, while the typical mutual fund investor received a return of only 2.57 percent per year over the same period, earning less than inflation! Individual investors bought and sold based on their emotions, but if they would have just left the investments alone in the mutual funds, they would have fared much better.

As investors, we like to think that we can act rationally, but behavioral finance reveals that most of us act with emotional biases when making investment and money decisions. And most emotional investment decisions end up reducing returns. Let's take a look at three of the most common potentially destructive behaviors that any of us might fall prey to when it comes to making money decisions.

Dollar Equality

Are all of your dollars created equally? If you're like most people, the answer is no. The term “mental accounting” refers to the tendency to categorize and treat money differently depending on where it comes from, where it is kept, and how it is spent. This emotional compartmentalization is a significant reason investors unwittingly make big mistakes with their portfolios. Mental accounting can benefit you when it leads to treating college savings or retirement funds as “untouchable,” but compartmentalizing money can be financially disastrous when it leads to rash spending from some sources such as gifts, bonuses, or tax refunds. Imagine you unexpectedly receive a $5,000 gift, and you immediately rush out and spend your “found” money on that plasma TV that's been calling your name. Why didn't you save it or buy the TV with your last pay check? The money is all the same—but you just fell victim to “mental accounting.”

On the other hand, viewing some money as too sacred—such as an inheritance or a down payment on a house—can lead people to avoid the ups and downs of the market by opting for investment strategies that are far too conservative. However, this exposes them to the ruin of inflation.

Compartmentalizing your money can also lead you to be increasingly aggressive when the market is soaring, but become overly cautious when the market takes a down turn. That's just the opposite of conventional and disciplined investment strategy of buying low and selling high and can cost investors a lot of money in the end. A key to a profitable investment portfolio is objectivity, so it is important that investors learn to see all money equally—salary, savings, stocks, gifts, or even lottery winnings.

Pain from Losses Outweighs the Pleasure of Gains

One of the central tenets of behavioral economics is that people are loss adverse, meaning that a loss emotionally appears about three times larger to most people than a gain of equal size. This loss aversion means that people are often willing to take more risks to avoid losses than to realize gains! Even when faced with sure gains, most investors are risk-averse, but when faced with sure loss, they become risk takers. This is just the opposite of what you would expect from a rational investor and explains why people might be unwilling to sell an investment at a loss even though it might be the least risky decision.

Take those who invested in a high tech company years ago. The stock did quite well at first, but then it dropped like a rock and remained in a loss situation. Rather than take a loss, some refused to sell and hoped the stock would regain high prices. As a result, these investors lost the chance to diversify into other stocks, and what they thought was the most prudent course of action turned out to be the most risky with the least return. The investors ended up incurring more risk by avoiding the “loss.”

Inability to Predict the Future

As we've seen, one of the biggest mistakes investors make is basing buy and sell decisions on their emotions. But what if you believe you are acting with your head and not your heart? Is it possible to allow our emotions to override common sense without realizing it? Think about some of these mistakes that you thought made perfect sense at the time:

• Jumping into the stock market after it made big gains.
• Bailing out of the market after it had fallen.
• Buying funds that had the hottest performances last year.
• Selling funds that under performed because their investment style was temporarily out of favor.

One of the reasons for these undisciplined decisions is that people typically give too much weight to recent experiences, forgetting long-term averages. We tend to think that current trends will last forever, and we tend to be more optimistic when the market goes up and more pessimistic when it goes down. Think about how you felt about investing when the market was roaring ahead in 1999, compared to how you felt right after 9/11. When the market was hitting new highs, we couldn't wait to pour money in, and when it was tanking, we all rushed to the sidelines.

Remember, investing is one of the most emotional endeavors you will undertake. So don't underestimate the emotional side. Be realistic about who you are and how you react, and you will find yourself a step closer to becoming a Peace of Mind Investor.