You turn on the television and the media is raving about electric cars—the hottest new trend in the stock market. You feel like you’re missing out. In a panic, you buy some stocks. A few days later, you hear your friends talking about how software-as-a-service (SAAS) stock is gaining momentum in the market. In a rush, you make a few trades and buy some more stock.
You’re pretty confident in your ability to pick the best stocks. Every few days you make a few more trades to earn a higher return. If a stock starts to go south, that’s okay. You quickly sell it and buy another stock you’ve had your eye on – or maybe you had a stop-loss in place to protect yourself – because you know it’s all about timing the market.
I’ve just described the two biggest mistakes people make when investing: herding and overconfidence. Both of these mistakes are behavioral biases—meaning they cause us to make irrational decisions based on emotion. And here’s why they’re costing you big money.
Why Buying Trendy Stocks Doesn’t Work
Herding happens when investors chase certain stocks because other people are buying them. The fear of missing out on a profitable investment fuels these actions. As a result, herding drives up the price of stocks way beyond what they’re actually worth.
As the stock price continues to climb way beyond what it’s actually worth, demand grows. (I mean, who doesn’t want in on a stock doing this well?) As demand grows, an investment bubble forms. The second people are no longer willing to buy the stock at an inflated price, the bubble bursts.
This happens every single time people go after trendy stocks. Look back over the last 30 years alone. This is exactly what happened during the dot.com era in the 1990s and the real estate boom in the mid-2000s. And many economists predict we’re in a soon-to-pop tech bubble now.
Why You’ll Never Be Able To Successfully Time The Market
Overconfidence is when you have too strong of a belief in your ability to discern what is “really” happening in the market. This leads us to believe we can pick better investments and know when to buy and sell to optimize returns. (We don’t. We can’t. End of story.)
Timing the market is a bad idea because no matter how hard we try, how smart we get, or how much bandwidth we have access to, it doesn’t work. We can’t get better returns with better timing. No one can tell the future before it happens. No one can time the unknown.
A Proven Strategy For Investing (Works Over Time Every Time)
We’re hard-wired to make emotional financial decisions—it’s been scientifically proven. We can’t overcome our biases until we slow down and install a plan to help us make better choices.
Don’t let the frenzied media tell you when to make a move in the stock market. Instead, adopt this solid investment strategy and trust that you’ll have long-term success.
Appropriate Asset Allocation
When you allocate your assets, you’re dividing them up into three primary classes:
- Equity assets (like stocks, shares, business ownership)
- Fixed-income assets (like government, corporate, and municipal bonds)
- Cash or cash equivalents (like treasury bills, money market funds, and CDs)
Each of these categories is susceptible to a different level of risk (volatility) and return. Equities have provided greater long-term returns but come with more zigs and zags. Fixed-income provide more stability but lower long-term returns. And cash pays very little. Choose your combination of assets based on your risk tolerance and financial goals. Through asset allocation, you’re balancing risk and reward specifically for your plan.
When you diversify your portfolio, you’re choosing a variety of investments within each asset class mentioned above. It may be tempting to only put your money into investments that are doing well, but this is unreliable.
Diversification keeps us from putting all our eggs in the same basket. Instead of owning a ton of stocks in one company, you own many pieces of a lot of companies. These companies may be in various industries or even in various countries.
We can’t predict what’s going to be the next hottest thing in the market. Diversification gives us the best opportunity to earn a higher return while still playing it safe.
When you rebalance your portfolio, you’re realigning your asset allocation and diversification. As certain assets perform better than others, more of your money ends up in those investments. By rebalancing, you adjust your portfolio back to the percentages you originally set. You should do this annually at a minimum (maybe semi-annually in volatile times).
Let go of the idea that you have to be proactive about managing your investments. Rebalancing is a hands-off (passive) approach, but it leads to higher long-term returns because it forces the buy low – sell high discipline. Between 1992 and 2006, 80% of active investors lost money, and only 1% of them were profitable.
Always Invest More
Market returns alone won’t help you reach your financial goals. You must consistently invest more money to earn more money. That means you may have to spend less money in the short-term, to have more money in the long-term. These are trade-offs you must make if you want to reach financial independence.
Regardless of how the market is doing, add the same amount of money to your investments every month. If the market is up, you’ll buy fewer shares with your dollars. If the market is down, you’ll buy more shares. This is called dollar-cost averaging. My dad said it was the 8th wonder of the world. Research proves that this method (combined with patience) leads to a higher long-term return.
The Bottom Line
Fewer decisions are always better. Consistency works. This strategy will never make you a rich overnight, but it’ll pay off in the long run. Even when the market is zigging and zagging, and there are extended periods of highs and lows, you’ll come out on top. Take this mindful approach to money and your behavioral biases will never get in the way of your financial freedom.
At The Happiness Dividend, we diversify and rebalance your portfolio, so you don’t have to. It’s the easiest way to put your investing on autopilot and reach your financial goals. You just tell us how you want to use your money, and we chart the course to get you there. To get started, visit https://mindful.money/how-it-works.