Editor's note: This is the perfect time of year to set new goals. That's why we're closing out this week's holiday series with some valuable tips. In this piece, which we last shared in 2019, Dr. David Eifrig walks through how to build good investment habits... by training your brain to avoid three destructive pitfalls.
Also, the markets and our offices will be closed on Monday in observance of the New Year. Look for the next issue of DailyWealth on Tuesday, after the Weekend Edition. Enjoy the holiday!
If investing were easy, everybody would be rich...
It's tough to gain an edge on the market when it's made up of some of the smartest financial minds in the world.
And it's even harder to beat these professionals when you continuously make – often easily avoidable – mistakes.
Today, I want to go over three common psychological traps investors should avoid...
Trap No. 1: The Anchoring Trap
First impressions can be powerful. The anchoring trap happens when an investor is relying too heavily on what he or she originally thought.
Let's say you used to be a frequent shopper at Toys "R" Us years ago. If you ever needed a birthday present for your kids, Toys "R" Us always had the best toys at the cheapest prices. And its customer service was top-notch. As a result, any time someone brought up Toys "R" Us, the first thing you thought of was a quality company.
But what if you were so blinded by your initial perception of the company that you couldn't see the competitive environment was changing for Toys "R" Us?
For decades, Toys "R" Us was the dominant force in the retail toy world. But by the 2000s, families didn't need to go to Toys "R" Us to buy toys anymore... E-commerce giant Amazon (AMZN) made shopping for the same items a one-click affair.
So if you invested in this company during its heyday and held on, thinking that it was here to stay, you would have lost a lot of money when it declared bankruptcy.
You must always remain flexible when you invest. Things change constantly, and so should your thinking. Be open to new information. It's OK to change your opinions when the facts change.
Trap No. 2: The Pseudo-Certainty Trap
I see this one far too often. It deals with how much investors are willing to risk.
There are two parts to the pseudo-certainty trap: The first is when investors remove risk when their portfolios are performing well. You can think of it like this... A NASCAR driver won't win a lot of races if he slows down every time he is in the lead.
The second part of this trap is when investors seek risk when their portfolios are falling. This can be detrimental, and it's what you need to watch out for the most.
When most people start to see their portfolios turn red, they often act out of desperation. They pile on risk to try and win it all back. This is a huge mistake. Most likely, your bet won't pay off... And you'll lose even more money.
When the market is falling, don't try to time it. Most people think they can catch a falling knife, and it turns out they can't. They buy when they think the market is at a bottom, only to see stocks fall by another 15%.
Avoiding the pseudo-certainty trap is all about getting in when there is an uptrend – and getting out when there is a downtrend.
Trap No. 3: The Sunk-Cost Trap
We've all done it...
We've all bought a movie ticket, sat down in the theater, and then realized halfway through that it's a terrible movie. But we made it this far and we've already paid for it... so we might as well finish watching the movie.
We all have clothes in our closets that we know we're never going to wear, but we keep them anyway since we already spent the money on them.
And of course, the sunk-cost trap also happens when we buy a bad investment and refuse to sell it – even when it's obvious we're wrong. We see the stock plummeting, but we remain committed to the investment. And, worse still, we often put more money into the loser, thinking, "It has to go back up eventually."
This is easier said than done, but... know when to cut your losses.
Emotions make this hard to do. That's why I usually recommend investors use some sort of exit strategy. Stop losses are a wonderful tool for combating the sunk-cost trap. Whatever you do, know when you'll sell any investment – ideally, before you ever buy it.
The bottom line is, investing is hard... So don't make it harder. Be aware of these traps and actively think about ways to avoid them.
Here's to our health, wealth, and a great retirement,
Dr. David Eifrig
"Being right and making money are two very different things," Chris Igou says. Most investors don't realize it, but a great investment idea isn't everything. You can be right and still lose money. Usually, that happens for one important reason... Learn more here.
"It starts with a simple question that has profound implications... Are you a hedgehog or a fox?" Dan Ferris writes. As an investor, you need to know what works for you. But no matter how you answer, you'll find an important lesson to learn... Read the full story here.