Paul Merriman
Sound Investing For Every Stage of Life 

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This is what investors should really be afraid of

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Plenty of potential potholes await investors these days, but I think the biggest worry for most folks should be themselves.

Specifically, investors should worry about this: Our brains and our emotions are hard-wired to undermine good investing practices.

The bad news is that nobody is immune. To some extent, all of us are sometimes a little crazy regarding financial decisions.

The good news is that we can recognize many of these dangers. The even better news is that there’s an easy way to avoid most (if not all) of these perils.

I know many investment advisers and experts, and I can’t think of even one who would disagree with this premise: The biggest challenge faced by investors is dealing with psychological hurdles.

Sure, inflation is dangerous. Deflation is dangerous. Currencies, governments, trade deficits, debts, runaway spending, corporate greed, taxes, bear markets, misinformation, manipulation … the list of external dangers could go on and on.

But even in the face of all these threats, we may still be our own worst enemies.

Jonathan Clements said it this way: “If you want to see the greatest threat to your financial future, go home and take a look in the mirror.”

The best book I know on this topic — and I have read many — was written by Jason Zweig: “Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich.”

The book is entertaining and easy to read, and I recommend it often.

Zweig bases his 10 chapters (with titles like “Greed,” “Risk,” “Fear,” “Regret,” “Surprise,” and “Happiness”) on more than 100 academic and industry studies that probe the relationship between our thinking brains and our emotional reactions.

Nobel Laureate Daniel Kahneman described these two parts of our psyche as “thinking slow” (pondering rationally and reflectively) and “thinking fast” (reacting emotionally, with little or no real thought).

In this article I’ll tell you a handful of things you should worry about, citing examples from Zweig’s book. You might recognize some of them in yourself or in other people you know.

Then I’ll tell you how to overcome them quickly, easily and inexpensively.

You should worry when you catch yourself making “careful” decisions quickly, based on a gut feeling or minimal knowledge. Zweig cites the case of a physician in New York City who invested in a European-based company that makes farming and construction equipment.

His only reason for buying the stock, he told a friend, was that its ticker symbol matched his initials. “I just have a good feeling about it, that’s all,” he said.

In 1999 during the height of the technology boom, Zweig reports, the stock of Computer Literacy Inc. rose 33% in just one day, for one simple reason: It changed its name to something more hip: “”

Indeed, he says, companies that in 1998 and 1999 changed their corporate names to include .com, .net or “Internet” outperformed the rest of the tech industry by 63 percentage points.

None of these things, by the way, had the slightest beneficial effect on the stocks’ long-term returns.

So the next time you notice yourself thinking “I just have a good feeling about this” or “I usually have excellent intuition,” I hope you’ll regard that as a danger signal.

You should worry when you feel happy about an investment you’ve just made. When I was young and in the brokerage business, I was taught to sell the sizzle of a stock rather than the steak. The story motivates buyers, not the raw facts.

Zweig cites a study of 250 financial analysts in which more than 90% believed the best way to evaluate a company is to “arrange the facts into a compelling story.”

Portfolio managers have based major decisions on what feels right. Professional traders sometimes move billions of dollars in and out of stocks based on gut feelings.

Except for purely random chance, none of this produces long-term benefits.

You should worry when you fret about the huge number of things you need to be paying attention to in order to make decisions.

Zweig cites studies showing that our brains — like the brains of animals — cannot keep up with all the stimuli available. This leads to distractions that keep us from focusing on what’s really important.

I’ve written about this before: There are always 100 or more reasons that the market could go up at any time. And there are always 100 or more reasons the market could go down at any time.

With hundreds of variables, each of which might seem plausibly important, we can become paralyzed like deer in the headlights.

You should worry when you think you can predict what is going to happen. Zweig cites decades of studies showing that rats and pigeons are better than humans at staying “within the limits of their abilities to identify patterns, giving them what amounts to a kind of natural humility in the face of random events.”

Humans, on the other hand, are so sure they can identify patterns that they stubbornly ignore facts that even researchers point out to them.

Zweig’s description of this in his chapter “Prediction” is well worth the price of his book.

You should worry when you “know” how your investments have done, even though you haven’t looked at the facts carefully.

I have a friend who felt quite proud of his stock-picking prowess (fortunately with only a small part of his savings). Until, that is, one day his employer started requiring him to report his stock purchases and sales every three months.

Soon after he had to put the facts down on paper, my friend gradually realized that his actual results were considerably less impressive than the results he “knew” he had been getting.

Trouble was, he had been happily reminding himself about his winners while he conveniently ignored the losers.

Once my friend figured this out, he pretty quickly did the thing that I recommend as an antidote for all the points I’ve made. He admitted he was not the genius he had considered himself to be, he sold his stocks, then invested the proceeds in index funds.

If you invest in index funds, you don’t have to stay “happy” or keep tabs on hundreds of things that might influence the market SPX, +0.91%

You don’t have to make predictions. You don’t have to make sure your decisions are “carefully considered.”

Index funds don’t have enticing stories. They’re boring. They don’t suck you in to narratives designed to take your eye off the ball and your money out of your pocket.

The only “stories” an index fund investor needs to know are the asset classes, the expense ratios and the long-term performance and risk characteristics of perhaps a dozen carefully chosen funds or ETFs.

You can skip the homework and check out my index fund recommendations here and my ETF recommendations here.

This is the way you should invest. It will make your life simpler, more peaceful and almost certainly more prosperous.

In my latest podcast, I respond to questions and comments from MarketWatch readers about active and passive investing.

Richard Buck contributed to this article.