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Investment mistakes to avoid, according to behavioral finance

Here are five more investment mistakes that new investors should avoid

Video Transcript


- Successful investing requires something perhaps even more rare-- the ability to identify and overcome one's own psychological weaknesses. Experts in behavioral finance have a lot to offer in terms of understanding psychology and the behaviors of investors, particularly the investments that they make.

Here are five mistakes. Number one, anchoring-- when estimating the unknown, we stand by what we know. This is called anchoring. And investors often fall prey to it. We may cling to subpar companies for years rather than dumping them and getting on with our investment life.

Number two, confirmation bias-- too often we extrapolate our own beliefs without realizing it and engage in confirmation bias or treating information that supports what we already believe or want to believe more favorably. Our judgment of a previous decision becomes biased to accommodate the new information. This type of knowledge updating can keep us from viewing past decisions as objectively as we should.

Number three, mental accounting-- if you ever heard friends say that they can't spend a certain pool of money because they're planning to use it for their vacation, you've witnessed mental accounting in action. Mental accounting becomes a problem, though, when we categorize our funds without looking at the bigger picture.

Take your tax refund for instance. While we might diligently place any extra money into savings, we offer view tax refunds as found money to be spent more frivolously. Since tax refunds are, in fact, our earned income, they shouldn't be considered this way.

Number four, framing effect-- this addresses how a reference point, oftentimes a meaningless benchmark, can affect our decision. There's a tendency to avoid risk when a positive frame is presented but seek risks when a negative frame is presented.

And number five, herding-- following a stock tip under the assumption that others have more information is a form of herding. This isn't to say that investors should necessarily hold whatever investments they currently own. Some stocks should be sold whether because the underlying businesses have declined, or their stock prices simply exceeded their intrinsic value.

We can all be much better investors when we learn to select stocks carefully and for the right reasons and then block out the noise. Stay financially fit, friends.