Overcoming the 5 common mistakes that investors make

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We are big fans of emotion control when it comes to investing. Most of us know this famous Jesse Livermore quote: “Money is made by sitting, not trading.” And yet, we can’t help ourselves.

Michael J. Mauboussin of Credit Suisse has an interesting report out on how to make better decisions:

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Know the outside view

The outside view imposes a fundamental question: “What happened when others were in this position before?” Research shows that the inside view often yields predictions that are too optimistic, revealing a form of overconfidence. The outside view generally tempers that overconfidence and provides a much stronger foundation for thinking about how the future might unfold.

Conduct a pre-mortem

Rather than using the past as a guide for the present, the pr-emortem goes from the future to the present. Before you actually make a decision, launch yourself into the future, say one year from now, and pretend that you made the decision. Now assume the decision turned out poorly, and you must document the reasons for the failure.

Seek out naysayers

It is common for investment firms to position their portfolios to reflect a particular point of view or theme. Mind-sets can be good, of course, when they get everyone on the same page. But mind-sets are a problem if the world changes. So seek out naysayers, or “red-teams.” Red-teaming is a technique to offset the rigidity of mind-sets.

A red team attacks and a blue team defends. In this case, the blue team would be assigned to defend the mind-set that underpins the portfolio. The red team would be a small number of people who would be charged with contesting the mind-set. Red-teaming allows for an explicit challenge to the prevailing mind-set, and at a minimum forces the team members to seriously consider an alternative point of view.

Maintain a decision-making journal

Sometimes good decisions turn out poorly and bad decisions turn out well. Since our minds are biased to assume that the outcome reflects the level of skill, keeping track of the quality of our decisions is difficult. The primary way to focus attention on the decision-making process is to keep a journal that documents your thinking. This is how you impose accountability on yourself.

Be mindful of your surroundings and work to improve them

When we observe the behavior of others, we attribute that behavior to the individual’s disposition and not to the situation. But there is substantial evidence that shows that the situation exerts a very powerful influence on the decisions that people make.

For example, some investors that claim to have a long-term orientation focus disproportionately on the short term following a spell of poor results. Others claim to use a fundamental approach yet use charts to time trades. The divergence between what you say and what you do might be result of the environmental cues around you.

And remember this awesome quote from Phil Birnbaum:

“You gain more by not being stupid than you do by being smart. Smart gets neutralized by other smart people. Stupid does not.”

Source: Methods to Improve Decisions

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