In almost every area of life – whether it's marriage, the workplace, or taking care of our health – we are often our own worst enemies.
The realm of personal finance is no different. What's the biggest threat to achieving financial independence? Unfortunately, it's your own brain.
You can invest in all the right things, minimise taxes, and even diversify your holdings. But if you fail to master your own psychology, it's still possible to fall victim to financial self-sabotage.
The brain's design
Today's Canny view is based on a chapter of Tony Robbins' bestselling book, Unshakeable, which reveals the key psychological limitations of the human brain.
Our brains are wired to avoid pain and to seek pleasure. These natural instincts are powerful. But while extremely useful when we were hunter gatherers, these same instincts can be very troublesome when making financial decisions.
How do we surpass these survival instincts that have been hardwired into our brains over millions of years? And how do we get past the 100-plus cognitive biases that make it surprisingly difficult to invest? It may be easier than you think.
Investors just need simple systems, rules, and procedures that can protect us from ourselves and ensure the decisions around money we make are in our best long-term interest.
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In Tony Robbins' words, "What I've found again and again is that 80 per cent of success is psychology and 20 per cent is mechanics".
Six psychological pitfalls to avoid
Remember these pitfalls – and how to counteract them – and you'll be able to avoid the biggest mistakes often made by investors.
Mistake 1: Seeking confirmation of your own beliefs
Your brain is wired to seek and believe information that validates your existing beliefs. Our mind loves "proof" of how smart and right we are.
Even worse, this is magnified by the media echo chambers of the modern online world. News media tend to favour one point of view, Google and Facebook filter our search results. This can be exceptionally detrimental in investing.
Convincing yourself that a particular stock or strategy is correct, without taking into account contradicting evidence, can be the nail in the coffin of financial freedom.
The solution: Welcome opinion that contradicts your own. The best investors know they are vulnerable to confirmation bias, so they actively ask questions and seek qualifies opinions that disagree with their own.
Mistake 2: Conflating recent events with ongoing trends
One of the most common – and dangerous – investing mistakes is to believe that the current trend if the day will continue.
In psychology-speak, this is known as recency bias, or putting more weight on recent events when evaluating the odds of something happening in the future.
For example, an investor might think that because a stock has performed well recently, that it will also do well in the future. Therefore, the investor buys more – effectively buying at a high point in the stock.
The solution: Re-balance. The best way to avoid this impulsive and faulty decision-making is to commit to portfolio allocations (for example, 60 per cent stocks, 40 per cent bonds) in advance, and then re-balancing on a regular basis.
Mistake 3: Overconfidence
Very successful and driven people often assume they will be just as good at investing as they are at other aspects of their life. However, this overconfidence is a common cognitive bias: we constantly overestimate our abilities, our knowledge, and our future aspects.
The Solution: Get real and honest. By admitting you have no special advantage, you give yourself an enormous advantage – and you'll beat the overconfident investors those delude themselves in believing they can outperform.
Mistake 4: Swinging for the fences
It's tempting to go for the big wins in your quest to build financial wealth. But swinging for the fences also means more strikeouts – many which can be difficult to recover from.
The solution: Think long term. The best way to win the game of investing is to achieve sustainable long-term returns that compound over time. Don't get distracted by the noise, and re-orient your approach to build wealth over the long term.
Mistake 5: Staying home
This psychological bias is known as "home bias", and it is the tendency for people to invest disproportionately in markets that are familiar to them. For example, investing in your employer's stock, your own industry, your own country's stock market, only asset class etc. Home bias can leave you over weighted in "what you know", which can wreak havoc on your portfolio in some circumstances.
The solution: Diversify. Do so broadly, in different asset classes and in different stock markets. From 2000 to 2009, the S&P 500 only returned 1.4 per cent per year, but other markets picked up the slack. A well-diversifies portfolio would have done well, no matter what.
Mistake 6: Negativity bias
Our brains are wired to bombard us with memories of negative experiences.
In fact, one part of our brain – the amygdala – is a biological alarm system that floods the body with fear signals when we are losing money.
The problem with this? When markets plunge, fear takes over and it's easy to act irrationally. Some people panic, selling their entire portfolios to go into cash.
The solution: Prepare. The best way to avoid negativity bias is to:
Keep record of why you invested in certain securities in the first place, maintain the right asset allocation that will help you through volatility, partner with a trusted financial adviser to offer advice and focus on the long term, and avoid short-term market distractions.
Conclusion: Simple rules and procedures will make it easier for you to invest for the long term. They will help you:
• Trade less and lower transaction costs
• Reduce risk by diversifying globally
• Control the fear that could otherwise derail you
Will you be perfect? No. But will you do better? You bet! And the difference this makes over a lifetime can be substantial.
• Nick Stewart is the CEO and an Authorised Financial Adviser at Stewart Group, a Hawke's Bay-owned and operated independent financial planning and wealth management firm based in Hastings. Stewart Group provides free second-opinion on your current investments, insurance covers and retirement planning.
• The information provided, or any opinions expressed in this article, are of a general nature only and should not be construed or relied on as a recommendation to invest in a financial product or class of financial products. You should seek financial advice specific to your circumstances from an Authorised Financial Adviser before making any financial decisions. A disclosure statement can be obtained free of charge by calling 0800 878 961.