John Nofsinger, a behavioral finance expert and author of "Investment Blunders of the Rich and Famous (Prentice Hall)," says our foul-ups fit into three categories. Simplification. We see patterns in random events, such as stock price movements. Then we make investment decisions based on false patterns.
The desire to beat the market can lead to all sorts of money-losing problems. They range from chasing mutual funds based on past performance to succumbing to get-rich-quick schemes. Even a good mood can prove damaging when it comes to investing. Optimism tends to make investors less analytical and more likely to take bigger risks, he says.
Nofsinger cites research that shows the popular investment strategies--relying on market timing, investment analyst or newsletter advice, mutual fund rankings, and tracking of insider trading--don't work very long.
Research also demonstrates the limitations of relying on professional money managers. Pros make the same behavioral mistakes as individual investors.
Now that we know what's wrong, how do we fix it? Most investors spend too much time selecting securities and timing the markets, Nofsinger says. But he points out that 90 percent of an investor's return is based on how they allocate assets. The trick is to own different assets to spread your risk. A simple mix of 50 percent stocks and 50 bonds, for example, is half as risky as a 100 percent stake in the stock market.
Investors also need to be more realistic in their expectations of what they will earn in the stock market, he says. They should save more and minimize investment expenses. They should invest in stocks, bonds cash and real estate. They should also hedge against inflation by investing in real estate, precious metals and inflation-indexed Treasury bonds.
Alan Lavine and Gail Liberman are husband and wife columnist and authors of The Complete Idiot's Guide To Making Money With Mutual Funds, (Alpha Books).
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