Change Your Behavior and Make Money by Avoiding These Four Common Misjudgments

Why do so many investors lose money only to repeat the same cycle and lose money time after time? Well, a whole new field is examining that- it is called Behavioral Finance. This field illustrates the tendency for investors to become more optimistic when the market goes up and more pessimistic when the market goes down. It's this tendency that cause large numbers of investors to consistently buy high and sell low. The evidence challenges the efficient market theory which holds that individual investors act rationally and consider all available information in the decision making process.

You can avoid these mistakes by identifying and understanding some of the common misjudgments that investors make:

1. Stop waiting to break even -cut your losses and move money to a more promising investment. Most people don't want to admit that their original buying decision was a poor one. Get over it. Sell and move to what is right for you. Effective portfolio construction should focus on the relationship between asset classes not on individual security selection.

2. Don't watch the market; watch your portfolio. You should be optimistic when the market is up and optimistic when the market is down- that's a sign of a well diversified portfolio. A poorly diversified portfolio faces higher risk and lower returns. Your neighbor may strike it rich with a single stock or asset class but you will win with consistent long term success.

3. Lose the attachment to what you own. I see a lot of this with real estate holdings or stock that was inherited or company stock options. It may have been good over the last five years, but will it perform well in the coming years? Maybe and maybe not-but do you want to bet the farm on it? Be open to rebalancing every one to five years. Decide what your target asset allocation is (such as 60% equities-40% bonds) and stick with it until your situation changes (like early retirement).

4. A well constructed portfolio has diversification across asset classes, and an asset allocation that quantifies the risk you are willing to take with the return that you are projected to get. Know how much risk your portfolio is taking by understand terms like standard deviation and Sharpe ratios. A very volatile portfolio is the result of not knowing the risk in your portfolio.

An investment portfolio is just that- an investment. It's not the house, car, or boat. Keep track of all of your investment accounts-IRA, Roth, 401K, Brokerage, etc. like they are one account.

Knee jerk responses to a bad economy are disastrous to your financial health. Avoid these four mistakes, get a plan and stick with it.

2008© Fern Alix-LaRocca CFP® All Rights Reserved