So much of retirement planning and investing is dependent on understanding human behavior, particularly your own. When your planning and investment decisions are infected by emotion, impulse, or other bad behaviors, your retirement plan can go awry in a hurry. Because of this, I enjoy reading about the psychological aspects of personal finance. I recently concluded a series of articles published on the Psy-Fi blog. Each of the articles explored a common theme about investing: First, learn how not to invest. Second, do the opposite.
Once we understand what the bad choices are, we will learn to avoid them in our future planning. When we begin our retirement planning and investing, we cannot assume that we already know what doesn’t work. But we can study and acquire that information from the knowledge and experience of others. Read, ask questions, and read some more. If we omit this process, psychology tells us that our decisions will be biased towards our own experiences. That may not be a good thing. You may have been fortunate in a first experience buying a stock that was a high-flyer but for retirement investing, index funds are a better idea.
The second rule of learning how not to invest is overcoming our tendency toward “willful amnesia.” This is how the Psy-Fi blog put it:
The second most dangerous trap any investor can fall into is the “I knew it was going to happen” syndrome: the remarkable ability of people to decide that they can predict the future, but only after that future has already happened: an exercise in futility were it not so damaging to investment prospects.
When we tell (deceive) ourselves (in hindsight) that we knew how an investment decision would turn out, we build up a false sense of confidence, we repeat bad decisions, and we over-estimate our investment returns. All of these are bad. Instead, we should carefully, logically, and honestly look at our past behavior and outcomes. If we made a bad investment decision, we should not avoid it but use it to change our future behavior.
Isn’t it strange that so many people overestimate their investment returns when those returns can be empirically measured?
The third rule of how not to invest: Do not fear volatility. The Psy-Fi blog makes a very important point about the psychology of investors and the pricing of investments:
[T]he price of a stock, or your house, at any given point is what other people are prepared to pay for it. Unfortunately the price people are prepared to pay varies for lots of reasons, not all of which are sensible, and you don’t want to be in a situation where you have to sell at prices which are stupidly low. In fact, you want to be doing exactly the opposite and, if at all possible, taking advantage of these prices.
A simple way of reducing the psychological impact of short term volatility is to not watch the value of your retirement portfolio on a daily basis.
The fourth rule of learning how not to invest is one we’ve heard before: avoid confirmation bias. What this means is that when we are ready to act on an investment decision, this is the time to look for evidence that we are wrong. Instead, most investors look for evidence that they are right about their decision. We want to be told that we are doing the correct things with our money. Even some of the investing “rules of thumb” that we have learned and practiced over the years should be critically examined. A lot of them are actually “rules of dumb.”
The “How Not to Invest” series published by the Psy-Fi blog are among the best articles I have ever read on how to use knowledge of human behavior to benefit your financial planning. In my humble opinion, they are a must read for any investor and even more so for those of us (baby boomers) with a few years on us. Get started here and enjoy.