A growing field of study can save you from your worst instincts.
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By Morningstar.com | 10-21-11 | 06:00 AM | Email Article

Whether it's the Dutch tulip craze of the 17th century, the dot-com mania of the late 1990s, or the rush into real estate of the early to mid-2000s, there's no shortage of examples of investors behaving irrationally.

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In the world of traditional economists and finance professors, though, that's not supposed to happen. If investors are rational decision-makers, then emotion-driven bubbles shouldn't be possible. Yet human weaknesses can limit our ability to think clearly. Many studies of investor behavior have shown that investors are too willing to extrapolate recent trends far into the future, too confident in their abilities, and too quick (or not quick enough) to react to new information. These tendencies often lead investors to make decisions that run counter to their own best interests.

The idea that investor psychology can result in poor investment decisions is a key insight of an increasingly influential field of study called behavioral finance. Behavioral-finance theorists blend finance and psychology to identify deep-seated human traits that get in the way of investment success. Behavioral finance isn't just an interesting academic diversion, however. Its findings can help you identify--and correct--behaviors that cost you money.

What commonplace mistakes should investors avoid? Here are a few key behavioral-finance lessons worth heeding.

Don't Read Too Much Into the Recent Past
When faced with lots of information, most people come up with easy rules of thumb to help them cope. While useful in some situations, these shortcuts can lead to biases that cause investors to make bad decisions. One example is "extrapolation bias," the overreliance on the past to assess the future. Instead of doing all the necessary and possibly tedious homework in researching a potential investment, investors instead "anchor" their expectations for the future in the recent past.

The problem, of course, is that yesterday doesn't always tell you what tomorrow will bring. If you don't believe us, just ask investors who swarmed red-hot technology- and Internet-focused stocks in 1999 and 2000 expecting the good times to continue, or those who bought overpriced real estate in the mid-2000s with the expectation that "home prices always go up." They didn't, in many cases, and some people suffered huge losses.

That's worth keeping in mind if you're drawn to the strong performers of recent years, whether it's emerging markets or precious metals. The recent volatility in those areas is a reminder that the past is no guarantee of future performance.

As Wall Street Journal columnist Jason Zweig has said, "whatever feels the best to buy today is likely to be the thing you'll regret owning tomorrow." Morningstar's investor returns show this phenomenon at work. Investors tend to pour money into funds after they've performed well and rush for the exits after they underperform, resulting in much lower returns (or even losses) for average investors compared with funds' reported returns.

Realize That You Don't Know as Much as You Think
In a 1981 study asking Swedish drivers to assess their own driving abilities, 90% rated themselves as above average. Statistically speaking, that's just not possible. But most of us are just like the Swedes: We think we're more capable and smarter than we really are. As an investor, you should check your excessive optimism at the door. You might believe you're more likely than the next guy to spot the next  Microsoft , but the odds are you're not.

According to several studies, overconfident investors trade more rapidly because they think they know more than the person on the other side of the trade. And all that trading can be "hazardous to your wealth," as University of California, Berkeley professors Brad Barber and Terrance Odean put it in their 2000 study of investor trading behavior. The study looked at approximately 66,000 households using a discount broker between 1991 and 1996 and found that individuals who trade frequently (with monthly turnover above 8.8%) earned a net annualized return of 11.4% over that time, while inactive accounts netted 18.5%. Investors who traded most often paid the most in brokerage commissions, taking a huge bite out of returns.

All that trading might have been worthwhile if investors replaced the stocks they sold with something better. But interestingly, the study found that, excluding trading costs, newly acquired stocks actually slightly underperformed the stocks that were sold. That means that rapid traders' returns suffered whether or not fees were taken into account. Some researchers have come to a similar conclusion studying fund manager trading--standing pat is often the best strategy.

If you constantly check your portfolio, you may be tempted to take action at the slightest hiccups in your holdings or in the market. Limit the number of times you even look at your portfolio; a checkup once or twice a year will be plenty for most investors. That will help you stay disciplined and will save you money on transaction fees.

Keep Your Winners Longer and Dump Your Losers Sooner
Investors in Odean and Barber's study were much more likely to sell winners than losers. That's exactly what behavioral-finance theorists would predict. They've noticed that investors would rather accept smaller but certain gains than take their chances to make more money. On the flip side, investors are reluctant to admit defeat and sell stocks that are underwater in hopes of a rebound. As a result, investors tend to sell their winners too early and hang on to their losers for too long.

That's why it pays to have clear reasons in mind for your purchase of any investment right from the get-go. If your expectations don't pan out, then it's time to sell. Crafting an investment policy statement that lays out basic parameters for your portfolio and what you're looking for in individual securities is a key way to instill discipline in your financial decision-making process. This article includes basic steps for creating your investment policy statement as well as a template you can use to craft your own.

Periodically rebalancing--but not too often--is another way that investors can avoid mental mistakes when buying and selling. Rebalancing involves regularly trimming winners in favor of laggards. That's a prudent investing strategy because it keeps a portfolio diversified and reduces risk; it ensures that you periodically harvest your profitable holdings. But rebalancing too frequently could limit your upside. Instead, rebalance only when your portfolio is out of whack with your target allocations. Minor divergences from your targets aren't a big deal, but when your current allocations grow to more than 5 or 10 percentage points beyond your original plan, it's time to cut back. This article discusses rebalancing in depth.

Avoid Compartmentalization
One other key mental mistake is focusing on individual securities in isolation rather than looking at your portfolio as a whole. If you're adequately diversified overall, your portfolio won't exhibit big swings on a day-to-day basis. But individual holdings can and will gyrate around quite a bit, and that could lead you to focus a disproportionate amount of time and energy on certain positions at the expense of the big picture.

To help stay focused on how you're really doing rather than paying undue attention to one or two holdings, it can be useful to view your portfolio in aggregate by using a tool like Morningstar's Portfolio Manager. If you already have multiple portfolios on the site--for example, one for your IRA and one for your company retirement plan--you can also collapse them into one large portfolio. Simply click "Combine" from the "Create" menu. 

It's All About Discipline
Fortunately, you don't have to be a genius to be a successful investor. As  Berkshire Hathaway chief and investor extraordinaire Warren Buffett said in a 1999 interview with Business Week, "Success in investing doesn't correlate with IQ once you're above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing." It's true that not everyone is gifted with Buffett's calm, cool demeanor. But challenging yourself to avoid your own worst instincts will help you reach your financial goals.

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