between making smart financial decisions and making dumb ones.
The good news is that once you
realize your own mental weaknesses, it's not impossible to overcome
You're about to buy an engagement ring so you do some
research on prices. Most people say three months' salary is the general budget,
so you freak out and request a credit line increase.
What's really going on: Anchoring.
Anchoring happens when we rely too heavily on the first piece of information
offered when making decisions.
After encountering the "three month" rule, you find it hard to make a logical
decision based your own financial reality or your relationship. You may not
have three months' worth of salary to splurge on a diamond, but you decide to
spend within that range because you are anchored to that idea.
You're 27 years old, in excellent health and just got
promoted. You're so high on life that you can't fathom a time when you'll no
longer be young, fit, and financially stable.
What's really happening: Myopia.
Because you are unable to picture yourself
in old age, bad health, or cash-strapped, you're less likely to save for
unexpected events or your retirement. Myopia can be blamed for many depleted retirement
savings account in the U.S.
"Seduced by temporal myopia in their younger years, many people get around to
saving seriously for their retirement far too late in their career, in their
forties and fifties in many cases, which greatly reduces the amount of money
they will have available for their retirement," says Shlomo Benartzi, a
behavioral finance economist and author of "Save More Tomorrow."
If you're lacking motivation, try this handy experiment: Use Merrill Edge's Face Retirement
generator, which will take a photo of you as you are today and
generate an image of what you'll look like in retirement. Benartzi's own
research has shown that this kind of reminder can actually give people the kick
in the butt they need to start saving for retirement.
You're watching the market closely and see that a certain stock has been tanking
over the last few months. You give it another month, watch it drop again and
decide to sell it off before history repeats itself.
What's really going on: Gambler's fallacy.
When investors rely on past events to predict the future, they're shooting
themselves in the foot. If a stock is flying or floundering for a year, that
doesn't mean it will continue to do so in the next year, or even few months to
The same thing happens when you buy a lotto ticket because your buddy next
door just won $10,000 in a drawing. Just because he won doesn't change the odds
of you winning at all.
Keep your decision-making grounded in the real facts. Analyze your
investments before making any sudden moves or following trends.
It's open enrollment season for your company's health
care plan and the list of plans is so confusing that you put it off for days
until, finally, the deadline rolls around. You give up, re-enrolling in whatever
plan you already have.
What's really going on: Avoidance.
This is a form of procrastination that could really
cost you. There are a lot of meaty topics in finance, most of which are about as
fun to research as it is to get a root canal. But if you miss a dentist
appointment, you can easily reschedule. Screw up your health care election and
you could be stuck with the wrong plan for an entire year and pay dearly for
Another area prime for avoidance: 401(k) plans. You know you've got to enroll
so you just skip around until a decent plan name "speaks to you." Not only
could you have signed up for a plan with high fees or the wrong allocations for
your risk tolerance, but you will only wind up paying more fees when you
finally realize your mistake and have to switch plans.
In addition to a wealth of helpful tools and articles online, many retirement
plan providers offer free advisors who are on call to help navigate you through
the elections process. If they don't, It could be worth it to book a one-time
consult with a fee-only financial advisor.
A tech company you love just went public and you're
dying to buy in. You decide to do your homework, but you skirt over the negative
headlines, instead clicking on posts singing the company's praises.
What's really going on: Confirmation bias.
Investors aren't machines. We've got feelings and
like any normal human being, we can't help but selectively filter out opinions
that don't mirror our own. In doing so, we create a false sense of security that
can lead to some pretty boneheaded decisions.
If you want the full picture, you've got to
seek out information that contradicts everything you thought you knew about a
company before you can hope to form a balanced opinion.
It's April 2008 and the stock market has just hit rock bottom, taking half of your retirement savings down with it. Shell-shocked and devastated by the loss, you demand that your financial advisor pulls every last investment out of the market immediately.
What's really going on: Loss aversion.
Loss aversion plagues even the most experienced investors,
making them avoid potential gains because they're too afraid to take a
Anyone who ditched the stock market for fear of
further losses after the 2008 crash can blame loss aversion. The average
pre-retiree 401(k) balance actually doubled since the recession. People who
fled the stock market and never rebalanced their portfolios only rebounded by 25%.
Loss aversion can also have the opposite effect, causing investors to cling
too tightly to losing investments. Because it hurts to admit that they picked a
loser, they focus on selling off winners and hope the losers will rebound over
time. If they aren't careful, they wind up with a portfolio full of
You're a savvy investor and you know you've got the
goods to beat the market. So you jump in and start trading like a madman,
trusting your gut and your own due diligence not to lead you
What's really happening: Overconfident investing.
It takes seriously overconfident investors to kid themselves into thinking
they can beat the market when even the people whose full-time job is to
beat the market fail so frequently.
Terrence Odean's oft-mentioned study, "Trading is Hazardous to Your
Wealth," isn't just a cute bedtime story for investors looking
to stroke their egos. It actually shows that frequent trading caused by
overconfidence can kill your returns.
Of more than 66,000 households using a large discount broker in the
mid-1990s, those who traded most often (48 or more times a year) saw annual
gains of 11.4 percent, while the market saw 17.9 percent gains, Odean
You're still working on building up your emergency fund
and you just got a birthday check for $100. Instead of adding it to your savings
account, you treat yourself to a new coat or a haircut.
What's really going on: Mental accounting.
Mental accounting takes place when we
assign different values to money depending on where we get it from. If you had
earned that $100 by working overtime one week, chances are you'd treat it more
like regular income and save it.
Mental accounting is a big reason why we spend more money with credit
cards than using hard cash. It just feels "less" like money to us and therefore
it's much easier to spend.
Instead, repeat this mantra: "Money is money, no matter how I get it." And
the next time you use your credit card, ask yourself if you'd be spending that
money if you were using cash instead. If the answer is no, hold off.
A housing development in your county just went belly up and you've heard
investors are snapping up cheap plots for a steal. You've got no experience
flipping houses but what the hell? You're not about to miss out on a hot ticket
What's really going on: Herd mentality.
You've spotted a hot trend and you don't want to be the only schmuck out there who
didn't book a seat on the bandwagon. As human beings, it can be very uncomfortable
standing still while the rest of our peers head the other way looking like
they're having a ball. It's in our nature to want to join the party.
This causes a lot of problems when it comes to
investing. If you're willing to change course every time the herd moves, you'll
end up trading a lot more frequently and seeing your returns nibbled to bits by
transaction costs alone, not to mention what will happen if the herd leads you
Cotton on to a trend too late and you'll
just lose out when the herd moves on to hotter territory later on and your stock
plummets. It's just a vicious cycle that will only lead to selling low and buying
The only way to profit from a trend is to get there before anyone else and
the odds aren't in your favor.
Linked in: http://www.linkedin.com/profile/view?id=101576891&trk=nav_responsive_tab_profile