"Experience is the name everyone gives their mistakes," author and poet Oscar Wilde once wrote. And how right he was. But what if we could gain the benefit of our errors without having to pay a painful price?
That's exactly what we are tackling in this installment of Investing 101, as we identify behavioral mistake that will will cost you money. To do so, we contacted Lou Harvey, president and CEO of Dalbar, a Boston-based financial services research firm, who has studied and written about the matter for years and has compiled this list of the five biggest behavioral blunders.
1) Mental Accounting
As Harvey describes it, the hallmarks of this investing mistake are erratic behavior and an ever-changing risk tolerance. If you're the type of person who takes big risks in one area but takes almost none in another, you might be suffering the effects of mental accounting. In Harvey's words, it's like conceptualizing different buckets for risk, but then putting all the buckets in the same pool.
2) Herding, Following the Crowd
It's often stated on Wall Street that the market rarely rewards the masses or that stocks always take the course of inflicting maximum pain. "The crowd often is mistaken," Harvey says, "and very often late, too." The problem with being a follower, he says, is that the leaders — whether going in or out of an investment — typically make all the money. "The people who come afterward miss out," he says.
3) Narrow Framing
In a universe that has thousands of stocks to chose from, and almost as many mutual funds and ETFs to sort through, investors could seemingly research ideas forever. At some point, we are required to ''pull the trigger,'' so to speak, and oftentimes it's for the wrong reasons. Harvey says the costly part of the problem is how many people make decisions based on statistical performance of an investment without considering how that performance was achieved. He thinks it is ''dangerous" to simply look at the numbers in front of you and not what the underlying strategies are — or who the portfolio managers are.
4) Anchoring
Despite it's name, anchoring has nothing to do with staying put. No, anchoring actually is the tendency for investors to tie themselves, or tether themselves, to the same methodology, style or a previous experience. "Treating an investment in the same way as a previously successful investment," Harvey warns, is a recipe for losses. Just because buy-and-hold for three years worked once, doesn't mean it will work again. In short, he says investors shouldn't be anchored in the belief that all investments work the same way.
5) Diversification
Who ever thought diversification would be on a list of investor mistakes? But in this case, Harvey explains that investors sometimes delude themselves into thinking their holdings are diversified, when in fact they might be something like similar assets in different places. "One has to understand that it's a bit more complex than simply spreading your eggs into more than one basket," he says, pointing out that true diversification takes work.
