Turn Mind Games Into Mind Gains

We know a lot more about investing than we did 30 years ago.


I’m not talking about supercomputers, sophisticated algorithms or breaking down “big data.” No, the calculations that we’ve learned more about happen inside each investor’s mind.


Neuroscience and psychology have taught us that human beings aren’t hard-wired to be good investors. On the contrary: Evolution has programmed us to make bad decisions with finances. It’s hard to break those ingrained thought patterns, which is one reason that all of us at Investing Daily are aware of them. We work hard to keep ourselves and our readers from falling into the mental traps associated with investment decisions.


One of the nation’s experts on investor behavior happens to be our Editorial Director, Robert Frick, who has spent years studying how investors are influenced by emotion, rather than logic, when making investment decisions—even when they’re not fully aware of the reasons behind their decision. Bob wrote extensively about investor psychology and behavioral finance for Kiplinger’s Personal Finance magazine, and worked two years for the Allianz Center for Behavioral Finance as a researcher, writer and speaker.


Read on for a Q&A with Bob about the mistakes our mental wiring can prompt us to make and how to avoid them.


Bob, what are some of the most common mistakes that investors make?


It’s been proven by many studies that the worst wounds that investors suffer are self-inflicted. For example, investors tend to hold on to losers too long. They sell winners too quickly. They follow the herd even when they feel the herd is wrong.


Investors also tend to look only at information that confirms what they want to hear. You see that a lot in the political season as well: People believe only the polls showing their candidate is leading. I’ve seen this with my own friends.


It’s human nature. We’re hard-wired to make decisions based on our emotions rather than logic.


That’s why most investors in the stock market fail to achieve even the average gains of the market year after year. Across a broad spectrum of investors over years, it’s rare that someone can beat the market over time. And the funny thing is people who can’t beat the market are the mostly likely to deny their sub-par performance.


Have you been caught in these traps yourself?


I was burned in the dot-com bubble. I freely admit it. I should have known better. I got caught up in the “new era” story and put too much money in dot-com stocks.


How can investors break out of these hard-wired traps?


You have to be disciplined not to make emotional decisions.


First, you have to be aware of the traps. There are about a dozen that are well-documented by science. But even after you understand what these mental biases are, it’s extremely hard to break away from them. They’re like reflexes. Some of them are virtually impossible to overcome.


Take the herd instinct, for example. Not doing what everyone else is doing can actually activate the pain center of the brain. It’s physically painful.


Here’s another one: if enough people tell you something is true, even if it’s not true, you’ll start believing that it’s true. Your brain will override your logic circuit. In investing, that can get you in a lot of trouble.


I spoke earlier about the chronic underperformance of the market by most investors. One way I try to break through that is to own index funds in addition to actively managing my own account. At the end of each year, I can see exactly how I did versus the index. If I don’t beat the index, I transfer more money to an index fund.


And I’ve learned from my mistakes. After getting burned by the dot.coms, when the real estate bubble came along, I adjusted. I was making a lot of money in REITs, but I rebalanced every six months. I kept my REIT allocation at 15% of my portfolio, even though it was growing so quickly that it sometimes rose to 25%. But by remaining disciplined, I took out profits and ended up making money even after the crash.


How do the analysts at Investing Daily work to break through these traps?


One of the reasons I love what we do at Investing Daily is that we don’t have analysts who play the emotion game. Some advisers are momentum investors. They’re trying to ride other people’s emotions. I don’t think that works over time.


The more data you crunch and the deeper you go into analysis, the better results you’ll have. That analysis helps you break through your natural, emotional instincts and give you the courage to not follow the herd.


Jim Pearce’s IDEAL system, for example, is a disciplined, numerical system. He sticks to it regardless of his emotions. Certainly, his judgment complements what the numbers tell him, but at its basis it’s a numerical discipline that directs the Personal Finance Growth Portfolio.


Another of our analysts, Robert Rapier, of The Energy Strategist, is a genius at looking at mistakes the herd is making in energy investing. He looks at the numbers, but he’s also seen for decades how people get caught up in fads and trends. One of the big factors in energy, as in other sectors, is extrapolation. People think a trend will go on forever. Once a trend has been in place for more than a year, people forget what happened before that trend started. Short-term thinking is very powerful, and it takes someone who has been in an industry for a long time, like Robert, to know that people get caught up in these extrapolations and that the trend’s end is going to come.


If you’re disciplined, you can overcome some of these traps. But most people don’t have the time to do what’s necessary. That’s how we can help. Our analysts take the time to do the analysis and crunch the numbers. We don’t get caught up in fads. In fact, we help people save and even make money by warning our subscribers about fads.


Richard Stavros got our subscribers out of master limited partnerships before they crashed. He recognized that the MLP market was like Wile E. Coyote, still running even though he had gone off the cliff and was about to fall. Now he’s managing the Personal Finance Income Portfolio and has three models that beat all the emotion out of his picks.


In the end, the real antidote to these behavioral glitches is analysis. It kicks us out of the emotional, vulnerable part of our brain and into the logical part. That’s why I like the team of investing experts we have. They’re all logic-oriented, and they recognize when markets get out of hand.

Right now, we recognize that there’s a bond bubble. We’re counseling everyone to be prepared for it. Have cash on hand. Don’t go long on bonds. Don’t simply follow the crowd, or assume the current trend will continue indefinitely. Every day, we’re helping people deal with these emotional issues—and that makes a real difference.