How to Avoid Cognitive Investing Biases on the Road to Financial Independence

Cognitive Investment Biases

In celebration of Independence Day, your Money Guys are talking about how our emotions can interfere with achieving financial independence.

We all know that being invested in the stock market puts our money at risk, which can cause a roller coaster of emotions at times. When the market is up, we’re happy, and when it’s down, we’re depressed and anxious.

Letting your emotions influence your financial decisions, especially when it comes to your investments, is a bad idea. How can we push our emotions aside so they don’t cause us to make grave mistakes with our portfolio?

Brian and Bo give you the answers in this episode, and discuss 15 cognitive investing biases to avoid on the road to financial independence.

Don’t Let Your Brain Hold You Back When it Comes to Money

Rick Edelman’s book, “The Truth About Money,” reviews the cognitive biases investors are most at risk for, and Brian goes through each in detail. He provides insightful examples so you can recognize when your emotions might be controlling your investment decisions.

The first step in being able to avoid these biases is to simply be aware of them. All too often, we get caught up in our thoughts and rationality goes out the window. You don’t want to play around with your emotions or your money, especially when it comes to growing your wealth to reach financial independence.

Here are 15 cognitive biases to stay away from as an investor.

 

  • Intuition Bias: Do you rely on your gut to make investment decisions? It goes without saying that’s a big mistake!
  • Mental Accounting Bias: This is when we treat our money differently depending on where we’ve mentally allocated it.
  • Compartmentalizing Bias: If you have multiple investment accounts, are you factoring in the investments you’re holding in all of them when figuring out what to invest in? Or are you viewing each as a separate account? You shouldn’t compartmentalize your investments.
  • Pattern Recognition Bias: Many of us are guilty of seeking out patterns that don’t exist. This is why “past performance does not guarantee future results” exists.
  • Recency Bias: We have a tendency to focus on current events, and this might cause us to base future predictions on how the present is going.
  • Proud Papa Bias: This occurs when we fall in love with our investments, or when we have a personal interest in seeing a stock do well.
  • Optimism Bias: This is when we think bad things only happen to others – not us – which causes us to be overconfident in our investments and to underestimate risks.
  • Illusion of Control Bias: If you think your actions control events, you’re guilty of this one. Just because you purchase a stock doesn’t mean it will perform well.
  • Pessimism Bias: The opposite of optimism bias, this is when we second-guess all of our investment decisions and can’t take action.
  • Catastrophe Bias: A combination of the recency and pessimism biases, this occurs when we think another recession is just around the corner, and hold ourselves back from entering the market because of that belief.
  • Regret Aversion Bias: Have you ever made such a bad mistake, you take every measure you can to avoid making it again? This limits your opportunity, especially with your money.
  • Endowment Bias: This is when you overinflate the value of your investments, similar to how homeowners often think their home is worth more than it actually is.
  • Herd Mentality Bias: So many investors are guilty of going with the herd on investments, whether it’s with friends, coworkers, or the media.
  • Anchor Bias: This can happen when the price of a stock shoots up or down, and an investor makes a decision to buy based on what the previous and current price is. They’re not valuing the price correctly because they’re anchoring to the higher price.
  • Illusion of Attention Bias: This is prone to happening when you invest in individual stocks, and focus all your attention on how they’re performing. This distracts you from the total performance of your portfolio.

In short, don’t fall prey to your emotions. They won’t guide you to road that leads to financial independence. Instead, base your investment decisions on sound principles, thoroughly research your options, make use of reputable resources, consult with your financial advisor, and don’t forget to enjoy life along the way.

Money is a tool to accomplish what you want in life, but don’t let the market influence your emotions to the point of being miserable.

The Serious Impact of Investment Fees

InvestmentFees

Investing is a major part of building wealth and creating a nest egg that can work for you in the long-term. Unlike savings accounts, investing can result in remarkable returns on investment and can help beat the cost of inflation.

Investing is a key component to building wealth and paving your financial future. But there’s a not-so-hidden aspect that can slowly eat away at a nest egg if you’re not careful to guard against it: outrageously high investment fees.

The Serious Cost of Investment Fees

Investment fees may seem innocuous at first. But  they become more detrimental over time. Ignoring costs is a huge mistake.

Some of the worst fees appear in employer-sponsored 401(k) plans, and most people don’t even know how much the plan is costing them each year. Many employers are in the same boat, and simply don’t know the costs associated with the plans they’ve chosen for their employees.

Investors trying to go it alone may also end up paying more than if they had hired a trusted advisor working in their best interest, if they don’t understand how to evaluate funds or if they don’t know to pay attention to things like turnover in management, mutual fund fee structures, and other factors that can increase their expenses.

It doesn’t have to be this way. You need to learn how to manage those fees so you can maximize your returns.

How to Minimize the Impact of Investment Fees

Many people choose to invest their money because of the magic of compound interest, failing to realize that investment fees compound too. How can you avoid the pitfalls of investment fees as an investor and hold on to as much money as possible?

Be financially smart and choose low-cost options and do your due diligence when choosing a professional to help you manage your investments.

You’ll want to choose wisely when it comes to who manages your money too. Some financial advisors may take a large commission, which will eat away at your earnings. Choose a financial advisor who works as a fee-only planner and upholds a fiduciary standard.

Also, don’t forget to speak up! If you have an advisor or an employer that manages your 401(k), ask them about what investment fees you will be paying. Ask about any expense ratios, internal fees, commission fees, annual fees, trading fees and administrative costs that might cut into your investments.

You have a right to know and are entitled to that information, but you have to do your due diligence and ask. If your advisor isn’t transparent about fees and how they’re compensated, it’s time to find a new one.

And before investing in anything, think about rates, commission fees, managements fees, trading fees, and so on. Consider the long-term implications of how it will affect your portfolio.

If you’re in a position to make decisions around your company’s retirement plan options, you can do the following to potentially save thousands of dollars in fees for the employees of the business:

  • Establish a prudent process for selecting investment alternatives and service providers
  • Ensure that fees paid to service providers and other expenses of the plan are reasonable in light of the level and quality of services provided.
  • Monitor investment alternatives and service providers once selected to see that they continue to be appropriate choices

As an investor, empower yourself with information and do your research on any investment fees before funneling more money into any assets or funds. After all, it’s your hard earned money that you worked for — don’t you want to keep most of it?

5 Investment Mistakes Couples Make

Investment Mistakes Couples Make

Have you talked with your spouse about your investment strategy, or what the purpose is for your investments? Investing can be tricky enough alone, but it’s extremely important to include your other half in investment decisions so that you’re on the same page about how your money is being put to work.

If you haven’t yet discussed investing with your partner, you should read on to be aware of the common investment mistakes couples make so that you can avoid them.

Mistake #1: Only One Spouse Has Contact with a Financial Advisor

It doesn’t matter if one of you is more comfortable with the idea of investing. Both of you should be attending meetings and calls with your financial advisor because you’re in this together. You both have an equal stake in how your portfolio performs.

In the event that something happens to the spouse handling investments, the other will be lost when it comes to picking things back up. Avoid this burden by working as a team.

Mistake #2: Not Being Clear on Common Goals

You should be investing with a goal in mind — whether you’re aiming for early retirement, funding your children’s college expenses, or saving up for a down payment on a house in five years.

Are you and your spouse in agreement on your investment goals? If you haven’t talked about investing beyond “it’s the right thing to do”, then you should. Otherwise, you might face an issue down the road where one spouse wants to withdraw money early from a retirement account for an expense that was never discussed.

Mistake #3: Investing Without Being Informed

Just because your investments might be managed by someone else doesn’t mean you should blindly follow their advice. You should absolutely know what you’re investing in and be a part of the decision process.

Never be afraid to ask your advisor questions. They should be able to answer them honestly, and they should want you to understand the reasons behind their investment decisions.

Mistake #4: Not Taking Advantage of Employer Matching Contributions

Do you and your spouse have a 401(k) retirement plan offered through your employer? Are you contributing enough to receive the amount your employer will match?

If you don’t know the answers or aren’t sure, you need to look into this. You could be leaving free money on the table. You should be able to ask your HR department about the details of your retirement plan.

If you’re not sure what matching contributions are, here’s an example of how they work: If your gross annual salary is $75,000 and your employer matches contributions up to 6%, then that means you have to contribute 6% ($4,500) of your salary for them to match that contribution.

If you only contribute $3,000, then you’re missing out on $1,500 from your employer. Likewise, anything above $4,500 won’t be matched, but you’ll still be funding your retirement.

Mistake #5: Being Unaware of How Your Advisor is Paid

One of the biggest mistakes you can make is hiring an advisor without knowing how they get paid. Are they fee only, do they get paid a commission, or a hybrid of both?

This is important because you want to ensure there’s no conflict of interest when your advisor recommends certain products to you. If they make a commission off of sales, then they might not be looking out for your best interests.

You should also check to see if your advisor is a fiduciary. If they are, then there’s no doubt they’ll be acting in your best interests, as financial fiduciaries are required to do so upon taking an oath.

To avoid these common investment mistakes couples make, remember that investing requires teamwork. Neither of you should be working alone when it comes to financial matters.

If you don’t have confidence in your knowledge of investing, you can always learn from the many resources available to you online. Building wealth through investing will ensure a successful financial future, and it’s not a matter to take a backseat on.

Knowing When to Go Pro

Hiring a professional financial planner could possibly be the key that unlocks the door to your financial success.  At the same time, choosing the right advisor to work with is an important decision that can often seem overwhelming.  In today’s show, we discuss the services that planners will and will not provide as well as key things to look for when hiring a pro.

In the March edition of MoneyAdviser, Consumer Reports outlined what typical fee-only planners will and won’t do for their clients:

What they will do:

  • Help you figure your net worth:  Typically, a planner will have the client gather the necessary data and then create a statement to uncover other planning opportunities, such as insurance analysis or estate planning.  (Do-it-yourself tip:  Collect current statements for all assets and liabilities and use an online net worth calculator, such as Mint or Yodlee, to determine your net worth each year.)
  • Advise you on 401(k) investments:  Your planner should be looking at all the pieces of your financial puzzle, including your 401(k) to ensure that your saving and investing goals line up across the board.  (Do-it-yourself tip:  See if your 401(k) plan sponsor offers access to investment guidance or check out the online retirement-planning program, Financial Engines, for additional support.)
  • Help you invest a lump sum:  A planner should be able to offer tax-efficient investment advice to their clients, as this is a core activity of financial planning.  (Do-it-yourself tip:  Use Morningstar software to research mutual funds and stocks for your portfolio.  Also, check out Bo’s Money-Minute about investing in a lump sum vs. dollar cost averaging.)
  • Determine if you’re properly insured:  Your planner should be able to evaluate your insurance needs, as well as refer you to an agent that can provide the coverage.  (Do-it-yourself tip:  Do as much research as possible and shop around for the best rates.)
  • Assess if you’ve got enough to retire:  A planner can determine whether you are on track for retirement or if you need to explore other options, such as working longer or changing your lifestyle.  (Do-it-yourself tip:  Assess your potential income sources, including Social Security, and use an online tool to calculate where you stand.  Consumer Reports recommends T. Rowe Price’s Retirement Income Calculator and Analyze Now’s Free Retirement Planner.)
  • Coordinate your retirement income:  Planners can determine the best method for drawing funds from your various retirement accounts, while considering tax consequences.  (Do-it-yourself tip:  Consumer Reports advises that unless your retirements consists entirely of Social Security and a pension, you might want to consult a professional on this one.)
  • Help you plan for college funding:  A planner can guide you on the best ways to finance your child’s education.  (Do-it-yourself tip:  Visit www.collegeboard.com, www.savingforcollege.com, and www.finaid.com for additional resources.)

What they won’t do:

  • Help you pay down debt:  As a general rule, fee-only financial planners refer such clients to a debt counselor or a bankruptcy attorney.  (Do-it-yourself tip:  Contact the National Foundation for Credit Counseling if you need help with debt.)

The gray area:

  • Help you control your spending:  While many planners recommend following a budget, it’s not cost effective for you or the planner to spend hours together developing a detailed budget.  Most planners are interested in overall cash flow and will recommend cutting back if needed.  (Do-it-yourself tip:  Create a spreadsheet or utilize budgeting software like Quicken, Yodlee, or Mint.)
  • Create an estate plan for you:  Planners can help you decide the structure and tax efficiency of your estate, but an estate-planning attorney will be needed to draw up wills, trusts, and end-of-life documents.  (Do-it-yourself tip:  Contact an attorney to prepare or review your documents.)

If you decide that hiring a financial planning professional would be beneficial for you, the following credentials should stand out to you:

  • Certified Financial Planner (CFP):  holder has passed a 10-hour exam, has at least three years’ financial planning experience, and has completed an approved course of study.
  • Chartered Financial Consultant (ChFC):  requires eight college-level courses in financial planning and 30 hours of continuing education every two years.
  • Certified Public Accountant/Personal Financial Specialist (CPA/PFS):  CPA with specialized training in personal finance.
  • NAPFA – Registered Advisors:  holder meets strict education and professional requirements for membership in the National Association of Personal Financial Advisors, for fee-only planners.
  • Chartered Financial Analyst (CFA):  holder completes a series of three six hour exams and has four years of qualified work experience.

Hopefully this information will be helpful if you are considering hiring a professional to guide your finances.  Check us out on Facebook, YouTube, and please leave any questions or comments below!

 

Links to other things mentioned in today’s show:

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