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Why Do Smart People Make Bad Investments?

Rob Russell

Want to be a smarter investor? Are you seriously committed to making serious money in the markets? Are you brave enough to adapt to change? If not, I can't help you. No one can. But if you're ready to put yourself back in control of your financial future, you first have to learn from the mistakes of even the smartest and greatest investors.

One common thread among the greatest traders/investors is that they recognize what held them back from investment success early on. I think the biggest threat that keeps you from making large, sustained wealth is YOU.

That's right, the person you see in the mirror every morning is holding you back from really creating wealth in the markets. I know that might be a big pill to swallow, but your human nature does everything it can to sabotage your moneymaking dexterity. The good news is that we're all in the same boat. No one is exempt from this. But if you become self-aware, you'll be well on your way to joining the ranks of some of the top traders and investors.

My job in writing this column is to help you become a smart(er) investor, and that starts with becoming aware of certain innate human characteristics that deprive you of your awesome moneymaking potential:

Hindsight bias. Hindsight bias is an inclination to think that the world is more predictable than it actually is, based on events that have occurred in the past. Many investment decisions are made with a bias greatly tilted to the past. Just because a security has done well in the past does not mean it will continue to do so in the future.

Cognitive dissonance. Cognitive dissonance is an inner struggle that exists when evidence is present that tells someone their common beliefs or assumptions are wrong. This is a BIG hurdle for many investors. For example, if the last 12+ years are any indication, it's obvious that buy and hold is dead (was it ever alive?), but many investors wrongly cling to this belief even when presented with contrary evidence.

Confirmation bias. When people purposely seek out information that will confirm the beliefs they already hold to be true, while ignoring information that would contradict those beliefs, they are participating in confirmation. This bias causes people to overestimate their knowledge and underestimate risks, leading to overconfidence in their investment-selection abilities. This spells disaster.

Sunk-cost fallacy. The sunk-cost fallacy occurs when people continue on with an irrational behavior just because they feel that they have passed the point of no return. Once an investment has been made, it's very difficult for you to change course (cut losses short). The real pros know to cut losses short and let profits run.

Communal reinforcement. Communal reinforcement can form strong beliefs when a claim is repeated by members of a community instead of being backed by valid evidence. See buy and hold investing and the outdated portfolio approach of stocks and bonds.

For decades we've been told that investing for the long term as a buy and hold investor is the way to go, but where's the proof? Many times when these claims are made, they reference the last 70 years or so, but I found that curious since there's DJIA data going back to the 1800s.From my analysis, buy and hold has only worked in two markets: the biggest bull markets in U.S. history (the '80s and '90s). I don't think we're on a verge of another '90s bull market. Do you?

I believe smart investors are required to take a more active management roll in their investments with a clearly defined buy AND sell strategy among differing asset classes. Buy and hold is a mantra peddled by Wall Street and lazy advisers. As these widely held myths and conceptions are repeatedly claimed over many, many years, they weave themselves into the fabric of what we hold is true and accurate. Unfortunately, that's not reality.

Status quo bias. In general people tend to maintain their current path, which has been established by previous decisions. Change is difficult for anyone, because the disadvantages of leaving the status quo loom larger than the advantages. Putting it another way: Misery loves company. Change is hard, but change can be for the better as well.

If you can recognize and identify these human "faults," then you can begin to make better trading and investment decisions.

Robert Russell is CEO & CIO of the Ohio-based Russell & Company, a private wealth management firm specializing in helping affluent individuals ages 45 and up create and preserve their wealth. He co-hosts a radio show, authors The Rob Report blog, and is a frequent contributor to FOX Business and CNBC.

Securities offered through Kalos Capital, Inc., Member FINRA, SIPC. Investment Advisory Services offered through Kalos Management, Inc., 3780 Mansell Rd. Suite 150, Alpharetta, GA 30022, (678) 356-1100.

Russell & Company is not an affiliate or subsidiary of Kalos Capital, Inc. or Kalos Management, Inc.

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