• Financial Planning
  • Behavioral Finance
  • Five Steps for Gaining Control of Your Investments and Avoiding Mistakes

    by Carl Richards

    Five Steps For Gaining Control Of Your Investments And Avoiding Mistakes Splash image

    We just don’t know what will happen next. It’s a reality that can be hard to handle as an investor.

    From fiscal cliffs and debt ceilings to unemployment rates and quarterly earnings, it can feel like we’re just along for the ride. And this feeling that we lack control, combined with uncertainty about the future, can make it very difficult to behave when it comes to investing.

    Your goal for 2013 needn’t be finding the “best” investment or even the next Apple Inc. (AAPL). Instead, you (and your portfolio) should be better off if you focus on the things you can control and implement strategies that help you avoid classic investing mistakes. 1. Get Clear About Today

    Does it really matter what the market did today if you don’t understand your current financial reality? Too often we get caught up in the news around investing and forget that the primary source of investing success comes from having a solid financial foundation.

    But if getting clear about our current reality is so helpful, why have

    The best place to start is at the beginning by creating a personal balance sheet. Your goal is to discover where you stand financially right now. You don’t need a fancy spreadsheet or even a computer for this exercise. Just grab a blank piece of paper and a pen. Then draw a line down the middle.

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    On the left side, list all your assets in detail: bank accounts, the fair market value of your home, investment portfolio, etc. For every asset, list it and its value.

    On the right side, list all your liabilities: credit card debt, mortgage, school loans, etc. Again, get specific and list the actual amounts of each liability (Figure 1).

    If you don’t know the amount, call your bank, credit card company or your adviser. In this exercise, guessing isn’t allowed, so ask the questions and get the real numbers on paper.

    Then, add up all your assets and subtract all your liabilities. You now have your net worth.

    What does it look like? If you’re not happy with the number you see, you have two choices that will probably involve some hard work:

    • Increase your assets, or
    • Decrease your liabilities.

    If you’re wondering why I suggest starting with something so simple, it’s because I keep crossing paths with people who don’t know how their assets compare to their liabilities. And the reality is that if you don’t know where you stand today, then how will you ever figure out where you want to be tomorrow?

    2. Set Financial Goals That Matter to You (But Know They’ll Probably Change)

    When you invest, all that matters is your financial goals. Not your neighbor’s goals, or those of the guy at work or your brother-in-law. But I often see one of two things happen:

    • People don’t set any goals because
    • they’re overwhelmed, or
    • People get caught up in the goals of other people.

    When you invest, you need to do it with your financial future in mind and not anyone else’s (Figure 2). However, if you fall in the group where you’re feeling overwhelmed, here are some things to keep in mind to help you set goals that matter to you.

    These goals are guesses.

    While it is important to admit these are guesses, you should still make them the best guesses you can. Be specific. Just saying, “I want to save for college for my kids,” isn’t enough. How about, “I’ll find $100 to add to a specific 529 account on the 15th of each month”?

    Even though you need to be specific, give yourself permission to be flexible. An attitude of flexibility goes a long way toward dealing with uncertainty. There is something very powerful about having specific goals but not obsessing about them.

    These goals will change.

    It’s a continuing process, and it will change because life changes. But don’t let this knowledge stop you from setting financial goals. You need to start somewhere.

    Think of these goals as the destination on a trip.

    You would never spend a bunch of time and energy worrying about whether you should take a car, train or plane without first deciding where you are going. Yet we spend countless hours researching the merits of one investment over another before we even decide on our goals. Why are you stressing about what stocks to pick if you don’t have goals in mind?

    Prioritize these goals.

    Once you have them all written down, rank each goal in terms of importance and urgency. Sometimes you will have to deal with something that is urgent, like paying off a credit card bill, so that you can move on to something really important, like saving money for retirement.

    This is a process.

    If you set goals and then forget about them forever, that is a worthless event. This is a process. Since we’ve given ourselves permission to change our assumptions about the future as more information becomes available, we need to do it. Part of the process of planning involves revisiting your goals periodically to see how you are doing and making course corrections when needed.

    Let go!

    As important as it is to regularly review your progress, it’s also very important to let go of the need to obsess over your goals. Define where you want to go, review your goals at set times and in between let go of them! Goals for the future are important, but so is living today. Find that balance.

    3) Focus on What You Can Control

    Obviously, it’s easy to get distracted. And based on the questions I get, people are really distracted when it comes to money.

    • Should I buy this stock?
    • What do you think the market will do?
    • Will Europe go down in flames?
    • Will the economy ever recover?
    • But what if instead of asking those questions, we asked just these questions:
    • How much can I save?
    • How is my portfolio allocated?
    • Can I pick up some extra work this month?
    • Can I start a little business on the side?

    By asking just these questions we switch our focus to things we have at least some control over. We start to focus on our personal economy, instead of the global economy. Our personal economy becomes the filter for all the noise. Things like Europe, the market and individual stocks drop off our radar. Instead, we focus on information that helps us with the one thing we can control: ourselves (Figure 3).

    Obviously with so much noise, it can be incredibly hard to get this focused. But the sooner you figure out the value of this filter, the faster you’ll be able to make sense of the noise.

    4) Understand Your Time Frame

    We know the market will likely go up and down in the short term, yet people sometimes worry anyway about that fluctuation even if they don’t need the money for 20 years. Here are a few reasons why you may succumb to this behavior.

    You’re not confident in your investment process.

    If your portfolio is based on a thoughtful approach that relies on the best academic evidence we have, then it can be easier to stick with the long-term plan when things get scary in the short term. On the other hand, if what you own is a collection of random mutual funds instead of a well-designed, broadly diversified portfolio, it’s easy to get spooked. You start to wonder if the reason you’re losing money has something to do with the investment instead of just the normal ups and downs of the market.

    You’re watching too much news.

    Counteracting this one is simple, but not easy. Turn it off! Go on a media fast. If you’re confident in your investment process, what does the daily news about the markets do for you? Either ignore it, or get really clear about why you’re tuning in. Is it to be informed so you can have an intelligent conversation at dinner parties? Is it because you find it funny? I have a friend who refers to the Money section of USA Today as the “Funny” section. Whatever your reason for watching or following the news, just make sure you’re clear about it. If you’re watching out of habit and it makes you anxious, just stop it!

    You’re listening to people with different time frames than yours.

    Josh Brown has written about this issue on his blog, The Reformed Broker:

    “Everyone has an opinion and there is a lot of smart stuff being said for long-term investors, short-term swing traders and day traders out in the Wide World of Market Punditry—but the trick is not just figuring out who’s right, it’s determining whether or not something is relevant to your time frame.”

    If you’re an actual investor, and not a short-term trader, make sure the information you’re worrying about matches your time horizon. If you’re investing to pay for your kids’ educations 12 years from now, why do you care (at all!) about the latest apocalypse du jour?

    You’re projecting the recent past into the future…forever.

    This is a classic mistake, and one that is really easy to make. We are pattern-seeking animals and are notorious for looking at the recent past and thinking that it will last forever. We did it with tech stocks in the late 1990s, real estate in 2005 and now we’re just positive the European debt crisis will never, ever end. But remember, things change.

    You think we’re all moving to the hills to grow our own vegetables no matter what we do.

    I can’t help with this one. Until I learn differently, I still believe it’s in our best interest to be invested in a broadly diversified portfolio, since capitalism as we know it will not fall apart anytime soon.

    Your timeline is your own. Not your neighbors’, your co-workers’ or your brother-in-law’s. So do yourself a favor and make investing decisions based on what your time frame requires and not what the talking heads on TV are saying to fill a 24-hour news cycle. You’ll sleep better and will hopefully feel a bit less like running to the hills (Figure 4).

    5) Manage Your Behavior

    At some point in our lives, most of us have done something that we knew ahead of time made no sense. (Just think back to your teenage years.)

    After the fact, we’d shake our heads and wonder what we were thinking. Maybe it wasn’t our fault. Maybe the science shows that there are times when biology works against us and makes it difficult to act rationally.

    In the case of investing, both the science and the anecdotes seem to back up the idea that sometimes our biology gets in the way of our ability to assess risk. That matters a lot when you’re investing, according to John Coates, who wrote about it at Time.com:

    “…when we take risk, including financial risk, we do a lot more than think about it—we prepare for it physically. Body and brain fuse as a single functioning unit…[However] (e)ffective risk-taking morphs into over-confidence and dangerous behavior and traders on a winning streak may take on positions of ever-increasing size, with ever-worsening risk-reward trade-offs.”

    Even Warren Buffett, known to encourage investors to be fearful when others are greedy, and to be greedy when others are fearful, isn’t immune to biology, according to Dan Ariely, a behavioral science expert:

    “He is what behavioral economists call a sophisticate: someone who understands his irrationality and builds systems to cope with it.”

    Since irrational behavior appears to come naturally to us, we need to be like Buffett and build our own coping systems:

    • Acknowledge our problem. Most of the time, the market is not the problem; we are. We buy high because it feels good or our gut tells us we’re right. We sell low because we feel like we have to avoid extinction.
    • Write the money story. Look back at your track record in terms of bad behavior and see what story it tells. The great thing about financial decisions is that we have evidence. We have tax returns, brokerage statements and online transaction details. Take the time to see what your story says about your experience and write it down. Did you buy tech stocks in late 1999? Real estate in 2007? Bail out of stocks in 2008 or 2009? Or did you have a disciplined process that helped you cope with biology?
    • Establish guardrails. Think of it as building a preflight checklist. Those checklists aren’t there because pilots aren’t smart and experienced. They are there to prevent pilots from making a dumb mistake even though they know what they’re doing. In other words, recognize that no matter how smart you are, you can still make mistakes if you don’t install guardrails for investing. This could be as simple as a written statement (financial advisers call it an investment policy statement) that outlines what you will and will not do when it comes to investing. How much risk are you willing to take? When will you rebalance? How often will you reevaluate your plan? And who else is part of it? Knowing the answers to these questions can keep you from going off the road when trouble hits.
    • Automate good behavior. Because bad investing behavior tends to be our natural default, we have to automate the opposite. Check the box to rebalance your 401(k) automatically if you can and ask for that option if it’s not available. Arrange to have the money you want saved for education automatically pulled from your checking account monthly. Have a set day to review your spending and savings goals every month or quarter. Schedule a quarterly review of your investments. The things that get automated will vary from person to person, but they make fighting biology a little bit easier.

    Remember: there is rarely a time when investing skill matters more than investor behavior. So make your behavior count.

    Carl Richards is a certified financial planner and the director of investor education for The BAM Alliance (wwww.thebamalliance.com), a community of over 130 independent wealth management firms throughout the U.S.


    Jeff Carlson from MN posted over 3 years ago:

    The advice to create a personal balance sheet is priceless.

    James Joslin from NC posted over 3 years ago:

    Very good information. For all the noise in the marketplace and endless amounts of data, the main thing is to focus on our own behavior, timeframe, and investment needs.

    Peter Jochems from CO posted over 3 years ago:

    I'm a new member but a practicing CFP for many years. Great to see that the very basic net worth is used first. It really is the barometer of how one prioritizes their earned income, commits to savings, how dollars are spent, etc. it's pretty much the first thing I ask my clients to work on. Amazing how few really know the answer.

    Larry Taylor from SC posted over 3 years ago:

    Verg good advise, wish I a better way to really tell when the stock market topping out,
    The volity swings so rapidly it makes my head swim.
    Thanks AAII

    Durai Raghavan from TX posted over 3 years ago:

    I found this presentation useful but I was looking for more specific information but in that sense, was disappointed how thie article managed to stay on the sidelines. For instance, I being a retired person, am more interested in wealth preservation and it would have been great Mr. Richards talked about a few ways on how one can get this done

    Ramesh Patel from OH posted over 3 years ago:

    Lot of psychologizing and patronizing in the article although the whole piece is well organized. Little of practical use or application. Vague platitudes abound. As a previous comment noted, there is hardly much of specifics here as to how exactly all the principles as applied lead to actual investment success. A few examples of actual application can help.

    S Jones-Hendrickson from VI posted over 3 years ago:

    I find this to be a very powerful article, thought stimulating and a call for discipline. In the end, discipline will be the ultimate guide.

    Robert Lyon from NC posted over 3 years ago:

    Could AAII focus an article on investment behavior in retirement?

    Winthrop Harewood from IL posted over 3 years ago:

    GREAT article, thanks a million and one, for it.

    Marvin Glenn from AR posted over 3 years ago:

    This article reinforced my confidence in my cautious investment approach, and reminded me not to get too upset by missed opportunities.

    Rudolph Heider from MO posted over 3 years ago:

    article is too general. Need to show specific samples to be of use to the average person

    Walter Curtis from WA posted over 3 years ago:

    I'm in line with most of the above. As a retiree, I long for something with some specifics. This article certainly DID confirm that I am my own worst enemy. I've stopped watching CNBC and, having set up a reasonably balanced portfolio, try to only check my accounts on a monthly basis. My wife seconds that motion too!!

    Floyd Wright from TX posted over 3 years ago:

    Very helpful in my present situation. I am a retiree that needs to reexamine my financial positions. I agree that an article on retiree's preservation of investments would be very helpful.

    Muriel Chandler from IL posted over 3 years ago:

    As a retiree, I am looking for more information that will be helpful to me. I am eliminating CD's and I am searching for an upstart that may become another Apple. Guides to research new companies would be helpful and appreciated. Such things as how to do quick screenings of what and what not is important.

    This a very good article and it causes me to want more written this clearly.

    Dennis Roubal from MI posted over 3 years ago:

    Great organizational advice. For those looking for specifics, that is what financial planners are for; to help you decide what you should do. It can't be covered in an article.

    John Flynn from FL posted over 3 years ago:

    Excellent advice... The only step missing is monthly cashflow broken down into: Income (Long Term vs Limited Term) and Expenses (Fix vs Variable needs). This will give you a how much risk you need to take in order to meet your future growth to live a comfortable retirement. Why take look for the next Apple if all you need is a good dividend portfollio?

    Leslie Sublett from KS posted over 2 years ago:

    You sound like clones.

    Hildy Richelson from PA posted over 2 years ago:

    It is good to set goals, but setting goals without a system to achieve them can be very discouraging. Unlike institutions, individuals have finite lives. If you can systematically save that is one step toward solvency. If you put your money into high quality bonds yielding 4% or better than you can predict how much you will have at any given time. Though you might not experience the highs of the stock market, you won't suffer the lows either.

    Individual bonds are the only self-liquidating investment. You do not need someone else to buy what you are selling. They pay current interest that can be reinvested for growth or used as a paycheck substitute.

    Richard Abbott from FL posted over 2 years ago:

    I'm 84 years old and I use 115 minus my age in conservative balanced mutual funds, the rest in short to intermediate bond funds with 5 years cash in the money market to cover my expenses. I never sold anything in the 2008 through 2009 melt down. I'm up 165% since the lows in February, 2009. I did some re-balancing in the last 12 months by selling some stocks and placing the money in my money market.

    I owe a lot to the AAII article in the January, 2009 edition that stated don't "panic", don't "sell" and "stay the course". This article in the AAII Journal saved me well over a $100,000!!!

    Richard Abbott from FL posted over 2 years ago:

    I'm 84 years old and I use 115 minus my age in conservative balanced mutual funds, the rest in short to intermediate bond funds with 5 years cash in the money market to cover my expenses. I never sold anything in the 2008 through 2009 melt down. I'm up 165% since the lows in February, 2009. I did some re-balancing in the last 12 months by selling some stocks and placing the money in my money market.

    I owe a lot to the AAII article in the January, 2009 edition that stated don't "panic", don't "sell" and "stay the course". This article in the AAII Journal saved me well over a $100,000!!!

    John Knox from AL posted 9 months ago:

    I think it's a very good article. I also think one needs to have a cash flow sheet at least for a year in time and evaluate it every month. I inherently find keeping track of what I spend discomforting.

    John Landry from TX posted 9 months ago:

    I've used Quicken for a number of years for all of my bank, mortgage and brokerage accounts. The daily totals are all downloaded automatically, and I have only to check them to see my net worth for that day. The only problem with this easy access is that it leads to agony when the market and the net worth are down.

    With automatic downloading there is no need to "key" in entries, and once a month I reconcile the accounts for the paper statements.


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