Stop over-thinking your portfolio. Take a mental "time out" and try some deep-breathing exercises. Do whatever it takes to rein in your caveman brain, because right now, your mind is one of your biggest liabilities -- emotionally and financially.
That's right: The ingrained tools that keep us out of harm's way -- our drive to seek more and more information, to look for patterns, to compare options, and even to flee to safety -- are the very same ones that compel us to make boneheaded financial mistakes. Worst of all, often we're not even conscious that we're on a financial suicide mission until it's over.
Re-train your brain
The good news is that, with pointed, conscious effort, you can tame your gray matter and neutralize the psychological noise that leads to bad investing decisions. The first step is to recognize the analytical and emotional tripwires in your head.
Here are four major cognitive biases to focus on nipping before they get the better of you and your money.
Myopic loss aversion: When things go swimmingly, it's a snap to keep a long-term perspective. When the bad news keeps coming and we're terrified of losing money, our time horizons shrink dramatically. We no longer project what will happen to the market, or to our investments, over the course of the next three to five years. Instead, we focus on what happens over the next three to five minutes.
The cure: Go long. If you think like a short-term trader, then you'll be tempted to start acting like one. And right now, nothing could be worse for your sanity and your savings. Remember that investing success is not measured in minutes or even months: At The Motley Fool, we pick stocks for their long-term potential. Stick to your core investing principles and you'll do fine.
Information bias: With stock market news dominating every major outlet, we're bombarded with information -- and we keep watching because we just can't seem to get enough. Worse yet, most of the information isn't even relevant to the decisions we face.
The cure: Avoid information overload. Turn off CNBC. Immerse yourself in a novel, not the Internet news sites. Watching the market's conniptions and CNBC pundits' breathless banter simply makes the situation seem more dire and puts you at the mercy of our next cognitive bias ...
Social proof/herd mentality: It's easy to assume that when the market drops 18% over the course of the week, "it" knows something we don't. That assumption gains credence as others presume the same. Robert Cialdini, author of Influence: The Psychology of Persuasion, explains how this pile-on takes place: "The greater the number of people who find an idea correct, the more the idea will be correct." So everyone starts selling in a panic -- "The market is going down and I want out first!"
The cure: Ignore "them." Like your mother said, just because everyone else is jumping off a bridge doesn't mean you should. Instead, stick to your plan. Invest on a schedule and tune out the crowd. While everyone else is trying to game the system, you should be on the lookout for the opportunity to buy great businesses, with strong balance sheets, on sale. Tune out the noise and brush up on the basics. Hard times can be learning opportunities, which is a lot more productive than curling up in the fetal position and rocking back and forth for hours.
Anchoring: Focusing solely on a number is one of the most dangerous mental hiccups to your bottom line -- and lately we're drowning in a sea of numbers (stock prices, market indices, etc.). Here's how it works: Suppose you go to a used-car dealership and find a car priced at $7,000. You return later that afternoon to find that it has been marked up to $9,000. Nine grand strikes you as too expensive, even though you know nothing about the actual value of the vehicle. However, had you first seen the car priced at $11,250 and talked the salesperson down to $9,000, your mind would tell you that you were getting a great deal. The car is downright cheap! In both cases you anchored on a number -- a completely arbitrary number.
The cure: Anchor on value, not price. Anchoring is devastating in investing terms: Remember, a stock isn't cheap because it was more expensive yesterday or even last year. So rather than anchoring on price, anchor on value. Do your research and determine the price you're willing to pay for the company's future earnings stream before you look at the stock price.
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This article was originally published on Oct. 28, 2008. It has been updated.
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