Two Investment Errors

Smart investing is not just knowing what to do, but also means avoiding investment mistakes. The science of behavioral economics has identified many common mistakes that people make when they invest. Here are two to watch. 

Investing Mistake - Status Quo Bias

"Status quo bias is our tendency to automatically value more greatly the current situation over the alternatives. For example, show up on stock investing in an investors' unwillingness to sell what he owns and reinvest in better stocks. Of course it seems easier to leave things the way they are, but there is more than this involved in this mistake. 

An investor may be perfectly willing to spend time trying to find investments for "new" money, for example, but unwilling to spend an equal amount of time to replace an existing investment with a better. There is an attachment to what we already own, and this association may cost us, both in actual losses or lost opportunities to earn more money. 

To overcome this tendency, you should always look at your investments with the question, "If we was looking at this right now for the first time, I'd invest in it?" If not, you should probably sell investments and reinvest the proceeds in something else. After all, why would you leave your money in a stock you expect to go up 5% when there are others that you expect to go up in value by 25%? Invest in them! 

The exception to this is, of course, is that if transaction costs are high (generally not a problem with stocks). For example if you have a rental house worth $ 140,000, you can not just take the $ 140.00 and invest it elsewhere, perhaps because only clear $ 130,000 after expenses by selling. In this case you should ask if you'd do better with that $ 140,000 house or another investment, costing $ 130,000. 

Investment Mistake - The Endowment Effect

This error is due to our tendency to over-value what is ours. In one experiment a group of people were asked to put a price on different items, ranging from ashtrays to coffee machines and books. Persons in the second group were each given one of the items to keep on in a while. They were then asked to put a price on "their" object. These prices average much higher than those in the first group. Even a temporary "ownership" was enough to inflate the perceived value. 

How does this lead to investment mistakes? One way this happens in a person's tendency to hang on an investment just because he owns it. Especially if you've done some research and have developed a theory, it is hard to let go of "your" investment. Once again the solution to this is to look at each investment you own, as if you do not yet own it. Does it really make sense? 

Another good example of the endowment effect is always in real estate. You can love the new kitchen you put in a house, and really feel that it added $ 40,000 to the value of the house. Of course the market might value it at only $ 20,000. Think about it for a moment, and you may discover that you never would value others' kitchen renovations at more than that. 

This becomes a real problem when you try to sell investment property. we have seen people price a property too high and sit on it for years - costs incurred at all times. In the end, sometimes they even sell for less than they could have gotten in the first place. This can be an expensive mistake. Investments are not worth what you feel they are worth. They are worth only what the market will pay. Try to think like an outsider would avoid this investment mistake.