Financial experts agree that, with the right guidance, consumers can make better investment decisions than many professionals. That’s why personal-investing advisors Bonnie Biafore, Amy E. Buttel, and Carol Fabbri wrote Personal Investing: The Missing Manual.
This easy-to-understand guide will give you the tools and insight you need to evaluate financial products and make investments designed for success over the long term. Below, we feature an adapted excerpt from the book that will help you better understand what kind of investor you are and pick an investment strategy that best fits your personality.
In theory, investors are rational people, but you’re an investor and you know you’re not completely rational all the time. It turns out that some of your bad habits are hardwired into your brain—after all, those habits helped early humans survive in the wild, long before they started investing. For example, early humans who were part of a community survived, while individualists often became someone’s lunch.
Even today, people experience pain when they go their own way. The result is herd behavior–doing what everyone else is doing. For investors, herd behavior often means buying because everyone else is. Unfortunately, by the time you buy, the people who bought before you have inflated the investment’s price, so you may end up buying at a higher price than the investment is worth. If you sell after everyone else has sold, you do so at a price that’s often below the true value of the investment.
Our brains have evolved to seek immediate pleasure. Short-term successes, like killing your dinner or watching an investment go up in value, both release chemicals in the brain that give you pleasure and instill confidence. This quirk of evolution worked well for hunters, but isn’t so good for long-term investors.
To be a successful investor, you have to recalibrate your brain. You can teach an old dog new tricks—behavioral research shows that you can adopt better habits, and as you do, you build new neural pathways that strengthen that behavior. Each success reinforces your new good habits, and they grow stronger until they eventually become second nature.
Here, we describe the different types of bad habits you may exhibit as an investor and how to retrain yourself to be more successful.
Four Types of Investor
Researchers categorize investor behavior by risk tolerance, psychology, gender, and a gazillion other factors. However, all this research boils down to four investor types, based on the level of risk they’re willing to tolerate and on their confidence level, as the table below shows. If you recognize yourself in any of these descriptions, you can learn how to improve your investing habits. Most people see a little bit of themselves in a couple of the categories. This overlap is normal, so read all the descriptions and develop a plan that works for your personality.
Protectors hate change and they worry. If you’re a protector, you may work for the same company your whole life and keep your money in a savings account. You’re insecure about what you know about money and have a very low tolerance for risk. You’re emotional about investments and have trouble listening to logical arguments.
If you are a Protector, your bad habits may include an attachment to investments you already own, dislike of losses, fear of mistakes.
Protectors’ new habits
It’s tough to overcome your protector emotions, even if reason tells you to change your ways. Focus your emotions on your goals, and remind yourself how much you want to achieve them. Make small, gradual changes to your investments. Once you set up your investments, continue to make small changes to keep your portfolio balanced and on track. If you don’t think you can do either of these steps, consider having someone, like a financial advisor, help you with your investments.
If you’re a follower, you do just that: Follow the herd, because it makes you feel safe. Your risk tolerance is low, although you may think it’s higher. You’re insecure about your knowledge of investments. You tend to ignore your losses, don’t learn from your mistakes, believe information that’s familiar, and have a stellar record in picking last year’s winners
Followers’ new habits
The good news is that you have great potential. Education is the best tool for a follower. Because you think logically, you can learn about investing and put your knowledge to work making good investment decisions. Once you learn how to invest, research your investments before you make decisions. That makes it easier to stop following trends and listening to so-called experts.
Leaders are confident, aggressive, and contrarian. They’re strong thinkers, analytical, and want evidence before making a decision. On the other hand, they also take undue credit for wins, ignore information that contradicts beliefs, believe information that’s familiar and buy and sell frequently.
Leaders’ new habits
If you’re a leader, you need to accept a new definition of success. Instead of making changes frequently or trying to prove your success, learn to love a slow and steady approach to investing.
Education is a great tool for leaders. You can learn about investing and have the confidence to put your knowledge to work. Document all your investment decisions, why you make them, and what your expectations are. This will keep you grounded and control your urge to take credit when credit isn’t due.
Also, when making an investment decision, try to argue why you might be wrong. This will counteract your tendency for overconfidence. As a leader, your overconfidence could lead you to make spur-of-the-moment decisions that don’t match your original plan. When you decide on an investment, commit to that decision while your analysis is fresh in your mind.
Power players are aggressive and entrepreneurial, strong-willed and confident. Typically, they earn their own wealth and are very emotional about building it.
Power players are like leaders without the benefit of analytical thinking. Their emotions drive them to extremes. In addition to the pitfalls listed for leaders, power players also tend to have excessive egos and they tend to forget about losses.
Power players’ new habits
To succeed as long-term investors, power players need to ignore some of the strengths that helped them succeed in other areas of their life. If you are a power player, you need to focus on the big picture. Follow your instincts with 10% of your long-term investing money and leave the other 90% to the time-proven analytical approach. If you can’t overcome your emotions, work with someone who handles finances rationally.