Infographic: The 6 Biggest Mistakes Ordinary Investors Make
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The 6 Biggest Mistakes Ordinary Investors Make

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The 6 Biggest Mistakes Ordinary Investors Make

In many areas of life, we are often our own worst enemies. The realm of personal finance is no different.

What’s the biggest threat to achieving financial independence?

Unfortunately, it’s your own brain.

You can invest in all the right things, minimize fees and taxes, and even diversify your holdings. But if you fail to master your own psychology, it’s still possible to fall victim to financial self-sabotage.

The Brain’s Design

Today’s infographic is from Tony Robbins, and it uses data and talking points from his #1 Best Selling book Unshakeable: Your Financial Freedom Playbook, which is now available on paperback.

The graphic is based on a chapter in the book that reveals the key psychological limitations of the human brain. It turns out that these fallible survival instincts have been hardwired into our brains over millions of years, and they become very troublesome when we try to make rational financial decisions.

To overcome these instincts, investors need to adopt simple systems, rules, and procedures that can ensure the decisions around money we make are in our best long-term interest.

What I’ve found again and again is that 80% of success is psychology and 20% is mechanics.

– Tony Robbins

Six Psychological Pitfalls to Avoid

Remember these six pitfalls – and how to counteract them – and you’ll be able to avoid the biggest mistakes often made by investors.

Mistake #1:

Seeking confirmation of your own beliefs

Your brain is wired to seek and believe information that validates your existing beliefs. Our minds love “proof” of how smart and right we are.

Even worse, this is magnified by the online echo chambers of the modern world.

  • News media (MSNBC, Fox News, etc.) tend to favor one point of view
  • Google and Facebook filter our search results
  • Unsubstantiated rumors can run unchecked, as long as they reinforce existing points of view

This can be exceptionally detrimental in investing.

Convincing yourself that a particular stock or strategy is correct, without taking into account contradicting evidence, can be the nail in the coffin of financial freedom.

The Solution: Welcome opinions that contradict your own

The best investors know they are vulnerable to confirmation bias, and actively ask questions and seek qualified opinions that disagree with their own.

Ray Dalio, for example, seeks the smartest detractor of his idea, and then tries to find out their full reasoning behind their contrary opinion.

The power of thoughtful disagreement is a great thing.

– Ray Dalio

Mistake #2:

Conflating recent events with ongoing trends

One of the most common – and dangerous – investing mistakes is to believe that the current trend of the day will continue.

In psychology speak, this is known as recency bias, or putting more weight on recent events when evaluating the odds of something happening in the future

For example, an investor might think that because a stock has performed well recently, that it will also do well in the future. Therefore, she buys more – effectively buying at a high point in the stock.

The Solution: Re-balance

Our memories are short, so what can we do?

The best way to avoid this impulsive and faulty decision making is to commit to portfolio allocations (i.e. 60% stocks, 40% bonds) in advance, and then re-balancing on a regular basis.

This effectively ensures you are buying low, and selling high. When stocks to well, you sell some of them to buy other assets in the underweighted part of your portfolio, and vice versa.

Mistake #3:

Overconfidence

Very successful and driven people often assume they will be just as good at investing as they are at other aspects of their life. However, this overconfidence is a common cognitive bias: we constantly overestimate our abilities, our knowledge, and our future prospects.

The Solution: Get Real, and Get Honest

By admitting you have no special advantage, you give yourself an enormous advantage – and you’ll beat the overconfident investors that delude themselves in believing they can outperform.

If you can’t predict the future, the most important thing is to admit it. If it’s true that you can’t make forecasts and yet you try anyway, then that’s really suicide.

– Howard Marks

Mistake #4:

Swinging for the Fences

It’s tempting to go for the big wins in your quest to build financial wealth. But swinging for the fences also means more strikeouts – many which can be difficult to recover from.

The Solution: Think Long Term

The best way to win the game of investing is to achieve sustainable long-term returns that compound over time. Don’t get distracted by the short-term noise on Wall Street, and re-orient your approach to build wealth over the long term.

The stock market is a device for transferring money from the impatient to the patient.

– Warren Buffett

Mistake #5:

Staying Home

This psychological bias is known as “home bias”, and it is the tendency for people to invest disproportionately in markets that are familiar to them. For example, investing in:

  • Your employer’s stock
  • Your own industry
  • Your own country’s stock market
  • Only one asset class

Home bias can leave you overweighted in “what you know”, which can wreak havoc on your portfolio in some circumstances.

The Solution: Diversify

Diversify broadly, in different asset classes and in different countries. From 2000 to 2009, the S&P 500 only returned 1.4% per year, but foreign markets picked up the slack:

  • International stocks: 3.9% per year
  • Emerging markets: 16.2% per year

A well-diversified portfolio would have done well, no matter what.

Mistake #6:

Negativity Bias

Our brains are wired to bombard us with memories of negative experiences.

In fact, one part of our brain – the amygdala – is a biological alarm system that floods the body with fear signals when we are losing money.

The problem with this? When markets plunge, fear takes over and it’s easy to act irrationally. Some people panic, selling their entire portfolios to go into cash.

The Solution: Prepare

The best way to avoid negativity bias is to:

  • Keep record of why you invested in certain securities in the first place
  • Maintain the right asset allocation that will help you through volatility
  • Partner with the right financial advisor to offer advice
  • Focus on the long term, and avoid short-term market distractions

By failing to prepare, you are preparing to fail.

– Benjamin Franklin

Conclusion

These simple rules and procedures will make it easier for you to invest for the long term.

They’ll help you:

  • Trade less
  • Lower investment fees and transaction costs
  • Be more open to views that differ from your own
  • Reduce risk by diversifying globally
  • Control the fears that could otherwise derail you

Will you be perfect? No.

But will you do better? You bet!

And the difference this makes over a lifetime can be substantial.

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Investor Education

The Best Months for Stock Market Gains

This infographic analyzes over 30 years of stock market performance to identify the best and worst months for gains.

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The Best Months for Stock Market Gains

Many investors believe that equity markets perform better during certain times of the year.

Is there any truth to these claims, or is it superstitious nonsense? This infographic uses data gathered by Schroders, a British asset management firm, to investigate.

What the Data Says

This analysis is based on 31 years of performance across four major stock indexes:

  • FTSE 100: An index of the top 100 companies on the London Stock Exchange (LSE)
  • MSCI World: An index of over 1,000 large and mid-cap companies within developed markets
  • S&P 500: An index of the 500 largest companies that trade on U.S. stock exchanges
  • Eurostoxx 50: An index of the top 50 blue-chip stocks within the Eurozone region

The percentages in the following table represent the historical frequency of these indexes rising in a given month, between the years 1987 and 2018. Months are ordered from best to worst, in descending order.

RankMonth of Year Frequency of Growth (%)Difference from Mean (p.p.)
#1December79.0%+19.9
#2April74.3%+15.2
#3October68.6%+9.5
#4July61.7%+2.6
#5May58.6%-0.5
#6November58.4%-0.7
#7January57.8%-1.3
#8February57.0%-2.1
#9March56.3%-2.8
#10September51.6%-7.5
#11August49.3%-9.8
#12June36.7%-22.4
Average59.1%n/a

There are some outliers in this dataset that we’ll focus on below.

The Strong Months

In terms of frequency of growth, December has historically been the best month to own stocks. This lines up with a phenomenon known as the “Santa Claus Rally”, which suggests that equity markets rally over Christmas.

One theory is that the holiday season has a psychological effect on investors, driving them to buy rather than sell. We can also hypothesize that many institutional investors are on vacation during this time. This could give bullish retail investors more sway over the direction of the market.

The second best month was April, which is commonly regarded as a strong month for the stock market. One theory is that many investors receive their tax refunds in April, which they then use to buy stocks. The resulting influx of cash pushes prices higher.

Speaking of higher prices, we can also look at this trend from the perspective of returns. Focusing on the S&P 500, and looking back to 1928, April has generated an average return of 0.88%. This is well above the all-month average of 0.47%.

The Weak Months

The three worst months to own stocks, according to this analysis, are June, August, and September. Is it a coincidence that they’re all in the summer?

One theory for the season’s relative weakness is that institutional traders are on vacation, similar to December. Without the holiday cheer, however, the market is less frothy and the reduced liquidity leads to increased risk.

Whether you believe this or not, the data does show a convincing pattern. It’s for this reason that the phrase “sell in May and go away” has become popularized.

Key Takeaways

Investors should remember that this data is based on historical results, and should not be used to make forward-looking decisions in the stock market.

Anomalies like the COVID-19 pandemic in 2020 can have a profound impact on the world, and the market as a whole. Stock market performance during these times may deviate greatly from their historical averages seen above.

Regardless, this analysis can still be useful to investors who are trying to understand market movements. For example, if stocks rise in December without any clear catalyst, it could be the famed Santa Claus Rally at work.

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Investor Education

A Visual Guide to Stock Splits

If companies want their stock price to rise, why would they want to split it, effectively lowering the price? This infographic explains why.

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A Visual Guide to Stock Splits

Imagine a shop window containing large pieces of cheese.

If the value of that cheese rises over time, the price may move beyond what the majority of people are willing to pay. This presents a problem as the store wants to continue selling cheese, and people still want to eat it.

The obvious solution is to divide the cheese into smaller pieces. That way, more people can once again afford to buy portions of it, and those who want more can simply buy more of the smaller pieces.

cheese and stock splits

The total volume of the cheese is still worth the same amount, it’s only the portion size that changed. As the infographic above by StocksToTrade demonstrates, the same concept applies to stock splits.

Like wheels of cheese, stocks can be split a number of different ways. Some of the more common splits are 2-for-1, 3-for-1, and 3-for-2. Less common splits can take place as well, such as when Apple increased its outstanding shares by a 7-to-1 ratio in 2014.

Why Companies Do Stock Splits

Of course, stocks aren’t cheese.

The real world of the financial markets, driven by macro trends and animal spirits, is more complex than items in a shop window.

If companies want their stock price to continue rising, why would they want to split it, effectively lowering the price? Here are a some specific reasons why:

1. Liquidity
As our cheese example illustrated, stocks can sometimes see price appreciation to the point where they are no longer accessible to a wide range of investors. Splitting the stock (i.e. making an individual share cheaper) is an effective way of increasing the total number of investors who can purchase shares.

2. Sending a Message
In many cases, announcing a stock split is a harbinger of prosperity for a company. Nasdaq found that companies that split their stock outperformed the market. This is likely due to investor excitement and the fact that companies often split their stock as they approach periods of growth.

3. Reducing Capital Costs
Stocks with prices that are too high have spreads that are wider than similar stocks. When spreads—the difference between the bid and offer—are too large, they eats into investor returns.

4. Meeting Index Criteria
There are specific instances when a company may want to adjust its share price to meet certain index requirements.

One example is the Dow Jones Industrial Average (DJIA), the well-known 30-stock benchmark. The Dow is considered a price-weighted index, which means that the higher a company’s stock price, the more weight and influence it has within the index. Shortly after Apple conducted its 7-to-1 stock split in 2014, dropping the share price from about $650 to $90, the company was added to the DJIA.

On the flip side, a company might decide to pursue a reverse stock split. This takes the existing amount of shares held by investors and replaces them with fewer shares at a higher price. Aside from the general stigma associated with a lower share price, companies need to keep the price above a certain threshold or face the possibility of being delisted from an exchange.

Stock Splits Happen, but are not Inevitable

Alphabet will become the most recent high profile company to split their stock in early 2022. The company’s 20-for-1 stock split aims to make the share price more accessible to retail investors dropping the price from approximately $2,750 to $140 per share.

Conversely, Berkshire Hathaway has famously never split its stock. As a result, a single share of BRK.A is worth over $470,000. Berkshire Hathaway’s legendary founder, Warren Buffett, reasons that splitting the stock would run counter to his buy-and-hold investment philosophy.

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