Investment Mistakes - Two To Watch Out For
Half the battle of smart investing is avoiding investment
mistakes that eat up your capital. Many common mistakes that
people make when investing have been identified and studied in
the science of behavioral economics. Watch out for these two.
Two Investment Mistakes
Status Quo Bias
Our tendency to automatically value more highly the existing
situation over the alternatives is referred to as the "status
quo bias" in behavioral economics. In stock investing, for
example, this shows up in an investors unwillingness to sell
what he owns and reinvest in better companies. It's easier to
leave things how they are, but this isn't the only reason this
mistake is made.
Often an investor is willing to spend the time to find investments
for "new" money, but unwilling to spend an equal amount
of time replacing an existing investment with a better one. Why?
Because there's an attachment to the way thing are. It is comfortable
to leave some things unchanged. This of course can cost us, whether
in actual losses on an existing investment, or in lost opportunities
to make more money on new investments.
If you want to overcome this tendency, look at your existing
investments with the question in mind, "If I was looking
at this for the first time, would I invest?" If your answer
is no, sell the investment and reinvest the proceeds in something
better. Think about this for a moment. Why leave your money in
a stock you expect to go up 10% if there are others you expect
to go up 26% in value? Put your money in the latter!
There are exceptions to this rule, of course, like when transaction
costs are high, and will eat up some or all of the additional
gain from switching. This usually isn't a problem with stocks,
but if you have a rental house worth $140,000, you can't just
take that $140,000 and invest it elsewhere. You might only clear
$130,000 after the costs of selling the house. You need to ask
if you'll do better with that $140,000 house or putting $130,000
in another investment.
The easiest way to think about things is to forget about the
supposed "value" of your investments. Think of them
as worth what you can actually get out of them at the moment.
That rental house may appraise at $140,000, but you do have to
pay a sale's commission and other costs, so it makes more sense
to think of it as $130,000. For that matter, to properly compare
options, think of the cost of the next investment as the total
cost (there are expenses to buying too).
The Endowment Effect
People tend to over-value what is theirs. In one study, people
were asked to put a price on various objects, ranging from vases
to coffee makers and clocks. Those in a second group were each
given one of the objects to hold onto for thirty minutes or so.
When the subjects in this second group were later asked to put
a price on "their" objects, the prices averaged much
higher than those of the first group. This temporary "ownership"
was enough to inflate the perceived value of the things.
This is relevant to investment mistakes because of a person's
tendency to hang onto an investment just because he owns it.
Suppose you have done some research, and have developed a theory
before buying your investment. It's is difficult to let go now,
isn't it? You might watch as it goes down in value and still
hesitate to sell it. Again, the solution is to look at each of
your investments as though you didn't yet own them, and ask,
"is this a good place to put my money?"
The endowment effect is seen all the time in real estate investing
and home ownership. A couple loves the new kitchen they put in
a house, and feel that it added $40,000 to the value. But the
market might value only add $20,000 to the value of the home.
If
you consider this for a moment, you might realize that you would
never value someone else's kitchen renovations as highly as they
do, but in their position, you might make the same error in valuation.
It can be a big issue when you sell investment real estate.
I've seen people price a property too high and not sell it for
years - incurring expenses the whole while. They sometimes finally
sell for less than they could have gotten initially, just to
be rid of it - an expensive mistake to make. Neither stocks nor
houses nor other investments are worth what you or I feel they
are worth, but only what the market will pay.
Look at all your investments as though investing for the first
time to avoid these investment mistakes.
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