Smart investing isn't just knowing what to do, but also means avoiding investment mistakes. The science of behavioral economics has identified many common mistakes that people make when investing. Here are two to watch out for.
Investment Mistake - Status Quo Bias
The "status quo bias" is our tendency to automatically value more highly the existing situation, over the alternatives. For example, this shows up in stock investing in an investors unwillingness to sell what he owns and reinvest in better stocks. Of course it seems easier to leave things how they are, but there is more than this involved in this mistake.
An investor may be perfectly willing to spend the time to find investments for "new" money, for example, yet unwilling to spend an equal amount of time replacing an existing investment with a better one. There is an attachment to what we already own, and this attachment can cost us, whether in actual losses or in lost opportunities to make more money.
To overcome this tendency, you should always look at your investments with the question in mind, "If I was looking at this right now for the first time, would I invest in it?" If the answer is no, you should probably sell the investment and reinvest the proceeds in something else. After all, why should you leave your money in a stock you expect to go up 5%, when there are others that you expect to go up in value by 25%? Invest in those!
The exception to this, of course, is if the transaction costs are high (not usually a problem with stocks). If for example, you have a rental house worth $140,000, you can't just take that $140,00 and invest it elsewhere, because might only clear $130,000 after the costs of selling. In that case, you need to ask if you'll do better with that $140,000 house or another investment that costs $130,000.
Investment Mistake - The Endowment Effect
This mistake results from our tendency to over-value what is ours. In one experiment a group of people were asked to put a price on various objects, ranging from ashtrays to coffee makers and books. Individuals in the second group were each given one of the objects to hold onto for a while. Later they were asked to put a price on "their" object. These prices averaged much higher than those given by the first group. Even a temporary "ownership" was enough to inflate the perceived value.
How does this lead to investment mistakes? One way it does so is in a person's tendency to hang onto an investment just because he owns it. Especially if you have done some research, and have developed a theory, it is difficult to let go of "your" investment. Once again, the solution to this is to look at each investment you own as though you didn't yet own it. Does it really make sense?
Another good example of the endowment effect is seen all the time in real estate. You might love the new kitchen you put in a house, and really feel that it added $40,000 to the value of the house. Of course the market might value it at only $20,000. Think about it for a moment, and you might realize that you would never value someone else's kitchen renovations at more than that.
This becomes a real issue when you go to sell an investment property. I have seen people price a property too high and sit on it for years - incurring expenses the whole time. In the end, they sometimes even sell for less than they could have gotten initially. This can be an expensive mistake. Investments are not worth what you feel they are worth. They are worth only what the market will pay. Try to think as an outsider would to avoid this investment mistake.
Copyright Steve Gillman. To learn more about
Investing, and how you can get free e-courses and e-books, visit his website:
http://www.UnusualWaysToMakeMoney.com
