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SECTION 3

THE PSYCHOLOGY OF WEALTH

CHAPTER 8

SILENCING THE ENEMY WITHIN

The Six Money Mistakes Investors Make and How You Can Avoid Them

The investor’s chief problem—and even his worst enemy—is likely to be himself.

—BENJAMIN GRAHAM, author of The Intelligent Investor and mentor to Warren Buffett

Congratulations! You’ve made it through the rule book and the playbook and now possess the knowledge you need to become truly unshakeable.

You’ve learned what you need to watch out for, you’ve learned the facts that can free you from the fear of the inevitable corrections and crashes, and you’re fully armed with the winning strategies of the best investors on the planet. You’ve also acquired invaluable knowledge about fees, and how to find a truly qualified and effective financial advisor. All of this gives you an amazing edge, vastly enhancing your ability to remain clear-headed even in the face of uncertainty. You have a proven pathway to financial freedom!

But I have to ask . . . What could mess this up?

I’ll give you a clue: it’s nothing external. It’s you! That’s right. The single biggest threat to your financial well-being is your own brain. I’m not trying to insult you here! It’s just that the human brain is perfectly designed to make dumb decisions when it comes to investing. You can do everything right—invest in low-cost index funds, minimize fees and taxes, and diversify intelligently. But if you fail to master your own psychology, you may ultimately become the victim of a costly form of financial self-sabotage.

In fact, this is part of a much broader pattern. In every area of life—whether it’s dating, marriage, parenting, the workplace, our health, our fitness, our finances, or anything else—we have a tendency to be our own worst enemy. The problem is that our brains are wired to avoid pain and seek pleasure. Instinctively, we yearn for whatever feels likely to be immediately rewarding. Needless to say, this isn’t always the best recipe for smart decision making.

In fact, our brains are particularly prone to bad decisions when we’re dealing with money.

As we’ll discuss, there’s an array of mental biases—or blind spots—that make it surprisingly difficult to invest rationally. It’s not our fault. It’s part of being human. In fact, it’s built into the system inside your head, like a piece of faulty code in a computer program.

This chapter is designed to give you the key insights and tools you can use to free yourself from the natural psychological tendencies that derail so many people on the journey toward financial freedom.

Let me give you an example of a common psychological obstacle that we’re all likely to encounter. Neuroscientists have found that the parts of the brain that process financial losses are the same parts that respond to mortal threats. Think about what that means for a moment. Imagine you’re a hunter-gatherer searching for dinner in the forest when you’re suddenly confronted by a saber-toothed tiger with a serious attitude problem. Your brain goes into high alert, sending you urgent messages to fight, freeze, or run for your life. You might grab the nearest rock or spear so you can battle the beast, or you might flee and hide out in the safety of a dark cave.

Now imagine that it’s 2008, and you’re an investor with a big chunk of your life savings in the stock market. The global financial crisis slams the market, your investments take a tumble, and your brain begins to process the reality that you’re losing heaps of money. As far as your brain is concerned, this is the financial equivalent of that saber-toothed tiger roaring in your face, ready to make you his dinner.

So what happens? Red alert! The ancient survival mechanism inside your brain starts sending you messages that you’re in mortal danger. Rationally, you may know that the smartest move in a market crash is to buy more stocks while they’re on sale. But your brain is telling you to sell everything, grab your cash, and hide under your bed (more convenient than a cave) until the threat subsides. It’s no wonder that most investors do the wrong thing! It’s an unfortunate side effect of the human survival mechanism. We have a tendency to freak out because our brains believe our financial downfall is certain death.

And what counts is not reality, but rather our beliefs about it.

Our beliefs are what deliver direct commands to our nervous system. Beliefs are nothing but feelings of absolute certainty governing our behavior. Handled effectively, beliefs can be the most powerful force for creating good, but our beliefs can also limit our choices and hamstring our actions severely. So what’s the solution? How can we bypass the survival instincts that have been hardwired into our brains and belief systems for millions of years, so we can learn to stand firm in the face of a plunging market (or a hungry tiger)?

It may seem overly simplistic, but all that’s really required is a set of system solutions—a simple system of checks and balances—to neutralize or minimize the harmful effects of our faulty Flintstone wiring. There has to be a kind of internal control checklist since knowing is not enough. You need the systemic ability to execute every time.

Just think of the airline industry, where the consequences of human error can be devastating. For airlines, it’s imperative that they follow the correct procedures every time. So they minimize risks by implementing a series of system solutions and a series of checklists along the way. Consider the copilot, who provides an array of potentially life-saving checks and balances, just in case the pilot slips up. The copilot isn’t just there to merely steer the plane if the captain is in the washroom, but also serves as a second opinion for every decision point that may arise. Plus, it doesn’t matter how many thousands of hours they’ve flown—both the pilot and copilot constantly monitor detailed checklists to keep everybody safely on course, so they’ll arrive at their intended destination.

When it comes to investing, human error may not be a matter of life and death, but financial mistakes can still be catastrophic. Just ask those who lost their homes during the financial crisis, or couldn’t pay for their kids to stay in college, or can’t afford to retire. This is why investors also need simple systems, rules, and procedures to protect us from ourselves.

KNOW WHAT TO DO, DO WHAT YOU KNOW

The best investors are acutely aware of this need for simple systems because they recognize that, despite their abundant talents, they can easily mess up in ways that could cause them a world of pain! They understand that it’s not enough to know what to do. You also need to do what you know. That’s where systems come in.

Over my 20 plus years as a coach to Paul Tudor Jones, a key focus has been to constantly update and improve the systems he uses to evaluate and make investment decisions. In fact, when I first met Paul, he had just made one of the greatest investment trades in history, taking full advantage of the market on Black Monday in 1987—an infamous occasion when the market fell 22% in a single day. Paul produced an almost unimaginable return of 200% that year for his investors. But after this stunning success, he became overconfident—a common bias that you’ll learn more about in this chapter. The result? He became less rigorous in his adherence to the vital systems he’d accumulated over the years to become his most effective self.

In order to correct this bias, I set out to discover how his behavior as an investor had changed. I met with Paul’s peers (including some of the greatest investors in history, such as Stanley Druckenmiller), interviewed his coworkers, and watched videos of him trading during his most successful times. Based on this in-depth understanding, I worked with Paul to create a checklist: a simple set of criteria that he could use as his checks and balances before making any trade.

For example, one of the criteria we established was that before he could make any investment (or trade), Paul had to first establish in his own heart and soul that it was a hard trade—meaning it wasn’t a trade that everyone would make.

Second, he disciplined himself to make sure that there was asymmetrical risk/reward. In order to determine this, he would ask himself: “Is it a three-to-one? Is it a five-to-one? Can I get disproportionate rewards for the least amount of risk? What’s the potential upside and what’s the risk on the downside?” Third, he would sit down and ask himself, “Where are the breaking points for other investors? When will the price get so low or high that they will get out?” He would then use this insight to establish his own entry point: his target price for executing his investment. And finally, he would also establish his exit if his projections turned out to be wrong.

What’s the pattern here? The common link in Paul’s criteria is a simple set of questions that he uses to examine his beliefs and look at the situation more objectively.

And while all of these questions have provided a great checklist for Paul, what made it work was discipline. After all, a system is effective only if you use it! In order to be sure that he did, I asked Paul to write a letter to the members of his entire trading team stating clearly that they were not to make any investment until they checked with him first and asked the questions we outlined above: “Is this truly the hard trade? Does it really have asymmetric risk/reward? Is it a five-to-one or a three-to-one? What’s the entry point? Where are your stops?” To take it one step further, they were also instructed not to process any orders after the opening bell. In other words, they weren’t allowed to trade in the middle of the day. Why not? Because Paul realized that too often a trade in that stage of the game meant that he was reacting to the market, buying at the high price for the day and selling at the low, giving away his power and gifting someone else a better deal.

As you can see, great investors such as Paul understand a fundamental truth: psychology either makes you or breaks you, so it’s imperative to have a robust system that enables you to stay on target. Together in this chapter, were going to create a simple checklist with six items to watch out for and effectively counter to insure your long-term financial success.

80% PSYCHOLOGY, 20% MECHANICS

For four decades, I’ve studied the most successful people in many different fields, including investing, business, education, sports, medicine, and entertainment. And what I’ve found again and again is that 80% of success is psychology and 20% is mechanics.

Investor psychology is an incredibly rich and complex subject. In fact, there’s an entire academic field called “behavioral finance,” which explores the cognitive biases and emotions that cause investors to act irrationally. These biases often lead people to make some of the costliest investing mistakes, such as trying to time the market, investing without knowledge of the real impact of fees, and failing to diversify.

Our goal here is to keep things short and sweet! In this brief chapter, we’re going to explain what you really need to know about one of the biggest psychological pitfalls and how to avoid getting snagged by common investment mistakes your brain can cause you to make.

As Ray Dalio told me, “If you know your limitations, you can adapt and succeed. If you don’t know them, you’re going to get hurt.” By creating systematic solutions, you can free yourself from the tyranny of your conditioning and operate the control room like one of the best investors on the planet.

Mistake 1: Seeking Confirmation of Your Beliefs Why the Best Investors Welcome Opinions That Contradict Their Own

During the 2016 presidential election battle between Donald Trump and Hillary Clinton, you probably found yourself in heated political “debates” with friends. But did you ever have the feeling that it wasn’t a debate at all—that everyone had made up his or her mind already? People who loved Trump and loathed Hillary, or vice versa, felt so strongly that it often seemed like nothing could alter their opinions!

This was magnified by the way we consume media today. Many people watch TV channels that typically favor one point of view, such as MSNBC or Fox News; and our news is filtered more than ever by Facebook and other organizations. The result? It often feels like we’re in an echo chamber, listening primarily to people who share our views.

The 2016 election provided a perfect example of “confirmation bias,” which is the human tendency to seek out and value information that confirms our own preconceptions and beliefs. This tendency also leads us to avoid, undervalue, or disregard any information that conflicts with our beliefs.

For investors, confirmation bias is a dangerous predisposition.

Let’s say you love a particular stock or fund that’s performed exceptionally well in your portfolio over the last year. Your brain is wired to seek out and believe information that validates you owning it. After all, our minds love proof—especially proof of how smart and right we’ve been!

Investors often visit newsletters and message boards that reinforce their beliefs about the stocks they own. Or they pump their accelerator by reading positive articles about the hot sector where they’ve been earning fabulous returns. But what if the situation changes and that high-flying stock or sector starts crashing back to earth? How well equipped are we to change our perspective and recognize that we’ve made a mistake?

Do you have the flexibility to change your approach, or is your mind locked into its beliefs?

Peter Mallouk saw this phenomenon up close with a new client who had previously made a fortune on a biotech stock that had skyrocketed over a decade. The client had almost $10 million in this one stock. Peter and his team at Creative Planning set up an efficient plan for the client to diversify, dramatically reducing her exposure to this stock. The client agreed initially but then changed her mind, claiming she “knew” her beloved stock and understood why it would continue to soar. She told Peter, “I don’t care what you’re saying. This stock is what got me here!” Over the next four months, Peter’s team kept trying to convince her to begin the diversification process. But the client wouldn’t listen. During that time, the stock dropped by half, costing her $5 million. She was so upset that she dug in her heels even more and insisted on waiting for the stock to recover. It never did. If she had listened to this well-considered advice that contradicted her own beliefs, she would now likely be on track toward a life of total financial freedom.

In fact, this is also an example of another emotional bias called the “endowment effect,” in which investors place greater value on something they already own, regardless of its objective value! This makes it much harder to part ways and buy something superior. The truth is, it’s never wise to fall in love with an investment. As the saying goes, love is blind! Don’t get swept off your financial feet.

The Solution: Ask Better Questions and Find Qualified People Who Disagree with You

The best investors know they’re vulnerable to confirmation bias and, accordingly, do everything they can to counter this tendency. The key is to actively seek out qualified opinions that differ from your own. Of course, you don’t want just anyone with a different opinion, but rather someone who has the skill, track record, and intelligence to give another educated perspective. All opinions are not created equal.

Nobody understands this better than Warren Buffett. He consults regularly with his 93-year-old partner, Charlie Munger, a brilliant thinker who is also famously outspoken. In his 2014 annual report, Buffett recalled that Munger had single-handedly convinced him to change his investment strategy, persuading him that there was a smarter approach: “Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices.” In other words, Warren Buffett—the greatest investor in history—has openly attributed his success to his willingness to follow the advice of his partner, whose “logic was irrefutable.” That’s how powerful it can be to resist our tendency to seek opinions that merely confirm our own!

Ray Dalio, too, is obsessed with the idea of searching for divergent viewpoints. “It’s so difficult to be right in the markets,” he told me. “So what I’ve found very effective is to find people who disagree with me and then find out what their reasoning is. . . . The power of thoughtful disagreement is a great thing.” As Ray explains, the key question is: “What don’t I know?” You can benefit greatly as an investor by finding people you respect (ideally, this includes a financial advisor with an extraordinary long-term record) and asking them questions designed to uncover what you don’t know. Whenever I’m contemplating a major investment, I speak with friends who think differently, including my wise pal and genius entrepreneur, Peter Guber. I explain what I believe, and then I ask: “Where could I be wrong? What am I not seeing? What’s the downside? What am I failing to anticipate? And who else should I speak with to deepen my knowledge?” Questions like these help to protect me from the danger of confirmation bias.

Mistake 2: Mistaking Recent Events for Ongoing Trends Why Most Investors Buy the Wrong Thing at Exactly the Wrong Moment

One of the most common—and dangerous—investing mistakes is the belief that the current trend will continue. And when investors’ expectations aren’t met, they often overreact, leading to a dramatic reversal of the trend that previously seemed inevitable and unstoppable.

A perfect example of this phenomenon occurred election night in 2016. Hillary Clinton, by far the front-runner, was expected to win by a landslide—or at least by a “significant margin” according to nearly every poll. At noon on election day, bookies around the country gave her a 61% chance of victory. But by eight o’clock, the situation flip-flopped completely, giving Trump a 90% chance of winning. As the election results became clear, investors panicked because their expectations about the future were suddenly turned upside down. The market responded violently, with Dow futures dropping more than 900 points.

Ironically, the next day, the market snapped back in the opposite direction, with the Dow jumping 316 points as investors began to adjust to their new version of reality. We witnessed a Trump rally that continued for weeks. As I write this in December 2016, the S&P 500 just hit an all-time high for the third day in a row, the Dow Jones Industrial Average has scored its eleventh all-time high in a month, and the market has surged 6% in 7 weeks since the election!

How do you think investors feel right now? Pretty cheerful, that’s how! When you read that the market is “roaring ahead,” it’s hard not to feel a little rush of delight! Maybe you peek at your investment portfolio and notice that it’s the highest it’s ever been. Life is sweet!

Granted, I have no idea where the market is headed from here, and as the greatest investors in the world will tell you, neither does anyone else! But I do know that people get carried away at times like this. In the stacking of emotions and beliefs they start to convince themselves that the good times will keep on rolling! Likewise, when the market is plunging, they start to believe that it will never recover. As Warren Buffett says: “Investors project out into the future what they have most recently been seeing. That is their unshakeable habit.” What’s the explanation for this? There’s actually a technical term for this psychological habit. It’s called “recency bias.” This is just a posh way of saying that recent experiences carry more weight in our minds when we’re evaluating the odds of something happening in the future. In the midst of a bull market, the neurons in your brain help you to remember that your recent experiences were positive, and this creates an expectation that the positive trend is likely to continue!

Why is this so problematic? Because, as you know, the financial seasons can suddenly change, with bull markets giving way to bear markets and vice versa. You don’t want to be that guy who, after a long, sun-drenched summer, concludes that it’ll never rain again.

Great things are not accomplished by those who yield to trends and fads and popular opinion.

—JACK KEROUAC

I recently interviewed Harry Markowitz, a famous economist who won the Nobel Prize for developing “modern portfolio theory”: the basis for much of what we know today about how to use asset allocation to reduce risk. Harry is a financial genius, and, at the age of 89, he’s seen everything under the sun, so I was eager to speak with him about the most common investing mistakes we need to avoid.

Here’s what he told me: “The biggest mistake that the small investor makes is to buy when the market is going up on the assumption that the market will go up further—and sell when the market is going down on the assumption that it’s going to go down further.”

In fact, this is part of a much broader pattern of believing that current investment trends are bound to continue. Investors repeatedly fall into the trap of buying what’s hot—whether it’s a high-flying stock like Tesla Motors or the latest five-star mutual fund—and abandoning what’s not. As Harry puts it: “Whatever is going up, that’s what they buy!” People assume that these shooting stars will continue to burn brightly. But as we warned in chapter 3, today’s winners tend to be tomorrow’s losers. As you may recall, one study looked at 248 stock funds that received Morningstar’s five-star rating. Ten years later, only four of them kept that rank!

Even so, brokers routinely promote funds that outperformed in the previous year, only to see these recommendations underperform the following year. Investors tend to arrive just as the party is winding down. They miss out on all of the gains and participate fully in all of the losses. David Swensen summed this up neatly, telling me, “Individuals tend to buy funds that have good performance. And they chase returns. And then, when funds perform poorly, they sell. And so they end up buying high and selling low. And that’s a bad way to make money.” The Solution: Don’t Sell Out. Rebalance.

What the best investors in the world do is create a list of simple rules to guide them so that when things get emotional, they stay the course and remain on-target long term. You might want to start making a list of your own—an investment success checklist for the flight deck—that spells out where you’re trying to go as an investor, what you have to watch out for, and how you plan to navigate the journey securely. Share your flight plan with someone you trust—ideally, a sophisticated financial advisor. He or she can help you stick with the program by making sure you don’t violate your own rules with impulsive survival-brain decisions. Think of this as the financial equivalent of having a copilot to clarify and verify that you’re not heading into the side of a mountain!

An important component of these investment rules is deciding in advance how you’re going to diversify by allocating a specific percentage of your portfolio to stocks, bonds, and alternative investments. What will your ratio be? I If you don’t lock it down, circumstances will change and your mood will change with them. You’re likely to react to the moment, instead of sticking consistently with an asset allocation that’s ideal for you over time. If you recall, one of the solutions to this emotional stumbling block is to regularly rebalance your portfolio once a year.

What does that mean? Harry Markowitz gave me a clear example of an investor who starts with 60% of her portfolio in stocks and 40% in bonds. If the stock market soars, she might find herself with 70% in stocks and 30% in bonds. So she would automatically sell stocks and buy bonds, thereby restoring her portfolio to her original asset allocation ratio. The beauty of rebalancing, says Harry, is that it effectively forces you to “buy low and sell high.” Mistake 3: Overconfidence Get Real: Overestimating Our Abilities and Our Knowledge Is a Recipe for Disaster!

Forgive me for getting personal here, but let me ask you three questions. Are you an above-average driver? Are you an above-average lover? And are you better-looking than the average person? Don’t worry! You can keep your answers to yourself!

My reason for asking you these impertinent questions is to raise a fundamental point that could be vitally important to your financial future: humans have a perilous tendency to believe that they’re better (or smarter) than they really are. Again, there’s a technical term for this psychological bias: it’s called “overconfidence.” To put it simply, we consistently overestimate our abilities, our knowledge, and our future prospects.

Countless studies have described some of the wonderfully absurd effects of overconfidence. For example, one study found that 93% of student drivers believe they are above average. In another study, 94% of college professors considered themselves above average in the classroom. There was even a finding that 79% of students believed their character was better than most, despite the fact that 60% admitted they had cheated on an exam in the previous year. We each envision ourselves as a member of the “I’d never do that” moral minority.

All this reminds me of Lake Wobegon, the fictitious Minnesota town invented by the writer Garrison Keillor, “where all the women are strong, all the men are good-looking, and all the children are above average.”

So how do individual investors become overconfident? In many cases, a “professional” convinces them that there is a hot new investment that’s going to crush everything out there, and they allow that person’s passion to become their unwarranted confidence. In other words, one person’s salesmanship fuels another person’s misguided certainty.

Some individuals are extremely successful in running a business or living their lives, so they just assume that they’ll be equally as effective as an investor. But investing, as you know now, is more complex and challenging than it might initially seem to these high achievers.

Are certain people more prone to overconfidence? Finance professors Brad Barber and Terrance Odean examined the stock investments of more than 35 thousand households over five years. They found that men are especially prone to overconfidence when it comes to investing! In fact, men traded 45% more than women, reducing their net returns by 2.65% a year! When you add to this the additional costs of high transaction fees and taxes, you can see that excessive trading is truly a disaster.

But there’s another form of overconfidence that can prove even more costly; the perilous belief that you (or any TV pundit, market strategist, or blog writer) can predict what the future holds for the stock market, bonds, gold, oil, or any other asset class. “If you can’t predict the future, the most important thing is to admit it,” Howard Marks told me. “If it’s true that you can’t make forecasts and yet you try anyway, then that’s really suicide.” The Solution: Get Real, Get Honest

One of the best antidotes to overconfidence is to stand in front of a mirror and ask yourself this: “Do I really have an edge that will allow me to be a market-beating investor?” Unless you have some secret sauce—for example, the superior information and analytical skills that distinguish great investors such as Howard Marks, Warren Buffett, and Ray Dalio—there’s no rational reason on earth to believe you can outperform the market indexes over the long run.

So what should you do? Easy! Do what Howard, Warren, Jack Bogle, David Swensen, and other of the world’s greatest investors tell the average investor to do: invest in a portfolio of low-cost index funds, and then hold them through thick and thin. This will give you the market’s return, without the triple burden that active investors must carry: exorbitant management fees, high transaction costs, and hefty tax bills. “If you can’t add value, if you can’t create an asymmetry, then the best thing you can do is minimize your costs,” says Howard. In other words, “Just invest in an index.” Index funds also give you broad diversification, which is another powerful protection against overconfidence. After all, diversification is an admission that you don’t know which particular asset class, which stock or bond, or which country will do best. So you own a bit of everything!

Here’s the great paradox: by admitting to yourself that you have no special advantage, you give yourself an enormous advantage! How come? Because you’ll do so much better than all those overconfident investors who delude themselves into believing they can outperform. When it comes to investing, self-deception may be the biggest expense of all!

Mistake 4: Greed, Gambling, and the Quest for Home Runs It’s Tempting to Swing for the Fences, but Victory Goes to the Steady Survivors

When I was 19, I rented a house in an upscale community by the Pacific Ocean in Marina del Rey, California. One day I was dropping off some clothes at a local dry cleaner when a convertible Rolls-Royce Corniche pulled up, and a gorgeous woman stepped out. I couldn’t help but pay attention! We started chatting while she picked up her clothes, and I asked what she and her family did for a living. She told me that her husband was in penny stocks and had done really well. “I can see that,” I said. “Do you have any tips?” She replied, “Actually, right now, there’s an extraordinary one.” She gave me the name of a hot stock—and let me tell you, it felt like a gift from on high! A sure thing, right from the horse’s mouth! So I took $3,000, which was the equivalent of $3 million for me back then, and I bet it all on that one stock. And guess what happened? It went to zero! Boy, did I feel like an idiot.

As I learned from that painful experience, greed and impatience are dangerous traits when it comes to investing. We all have a tendency to want the biggest and best results as fast as possible, rather than focusing on small, incremental changes that compound over time. The best way to win the game of investing is to achieve sustainable long-term returns. But it’s enormously tempting to swing for home runs, especially when you think other people are getting rich faster than you!

The trouble is, you’re more liable to strike out when you swing for the fences. And that can be devastating. As we discussed in chapter 6, all of the best investors are obsessed with the idea of not losing. Remember our math lesson? When you lose 50% on an investment, you need a 100% return just to get back to where you started—and that could easily take you a decade.

Unfortunately, the desire to gamble is built into us. The gaming industry knows this well and ingeniously exploits our physiology and psychology: when we’re winning, our bodies release chemicals called endorphins, so we feel euphoric and don’t want to stop; when we’re losing, we don’t want to stop either, since we crave those endorphins and also want to avoid the emotional pain of losses. Casinos know how to manipulate us by pumping in extra oxygen to keep us alert and by plying us with free drinks to reduce our inhibitions! After all, the more we play, the more they’ll win.

Wall Street isn’t all that different! Brokerage houses love it when customers trade a lot, generating a blizzard of fees. They try to lure you in and hook you with advertisements that offer free or low-cost trades, along with market “insights” that will supposedly help you pick the winners. Yeah, right! Do you think it’s a coincidence that your online trading platform looks and sounds like a casino, with green and red colors, scrolling tickers, flashing images, and dinging sounds? It’s all designed to unleash your inner speculator!

The financial media reinforces the sense that the markets are just one giant casino—an intoxicating get-rich-quick scheme for speculators! It’s easy to get sucked in, which is why so many people lose their shirts by betting on the hottest stocks, trading options, and moving in and out of the market. All this activity is motivated by the gambler’s desire to hit the jackpot!

What you need to understand is that there’s a world of difference between short-term speculation and long-term investing. Speculators are doomed to fail, while disciplined investors who stay in the market through thick and thin set themselves up for victory, thanks to the power of compounding over time. Wall Street wins by getting you to be more active, but you win by patiently staying in the game for decades. Remember, as Warren Buffett says, “The stock market is a device for transferring money from the impatient to the patient.” The Solution: It’s a Marathon, Not a Sprint

So here’s the big question: In practical terms, how can you silence your inner speculator and force yourself to be a patient, long-term investor?

One person who’s obsessed with this question is Guy Spier, a renowned value investor. Guy began coming to my events two decades ago, and he credits me with inspiring him to model the best investors. He applied this idea by modeling Warren Buffett’s long-term approach to investing. In 2008 Guy and another hedge fund manager even paid $650,100 to charity to have lunch with Buffett!

As Guy sees it, one of the biggest barriers to success for most investors is that they get distracted by all the short-term noise on Wall Street. This makes it much harder for them to hold their investments for the long run and harness the awesome power of compounding. For example, they frequently check the performance of their investments, and they listen to TV pundits and market “experts” making useless predictions. “When you check your stock prices or fund prices on your computer every day, you’re feeding candy to your brain,” says Guy. “You get an endorphin hit. You have to realize it’s addictive behavior and just stop doing it. Move away from the candy!” Guy suggests checking your portfolio only once a year. He recommends avoiding financial TV entirely. And he suggests that you disregard all research produced by Wall Street firms, recognizing that their motive is to push products, not to share wisdom! “The vast majority of what purports to be analysis and information about the stock market is actually just designed to generate activity, to get us to pull the trigger because somebody out there will make money out of the fact that we’re being active,” he explains. “If it’s activity-generating information, we should shut it off.” Instead, Guy recommends creating “a more wholesome information diet” by studying the wisdom of ultrapatient investors such as Warren Buffett and Jack Bogle. The result? “You’re feeding your mind thoughts that will make it much easier for you to think and act long term.”

Mistake 5: Staying Home It’s a Big World out There—So How Come Most Investors Stay So Close to Home?

Humans have a natural tendency to stay within their comfort zone. If you live in the United States, you’re more likely to crave a cheeseburger with fries than a feast consisting of foie gras, poutine, or escargot. Likewise, you probably have a favorite grocery store, gas station, or coffee shop that you visit regularly, instead of venturing further afield.

When it comes to investing, people also tend to stick with whatever they know best, preferring to trust what’s most familiar. This is known as “home bias.” It’s a psychological bias that leads people to invest disproportionately in their own country’s markets—and sometimes to invest too heavily in their employer’s stock and their own industry.

For our cave-dwelling ancestors, home bias was a savvy survival strategy. If you ventured too far outside the ’hood, who knew what dangers might be lying in wait? But in our own era, investing globally actually reduces your overall risk. That’s because different markets are imperfectly correlated, which means they don’t move in lockstep.

You don’t want to be overexposed to any country—even if it’s where you live—because you never know when it will hit a rough patch. In the late 1980s, Japanese investors had 98% of their portfolios in domestic stocks. This paid off handsomely for most of the eighties, when Japan seemed to be on top of the world. Then in 1989 the Japanese market collapsed, and it’s never fully recovered. So much for “Home, sweet home!” A report by Morningstar showed that the average American investor in mutual funds had almost three-quarters (73%) of his or her total equity allocation invested in the US stock market at the end of 2013. Yet US stocks accounted for only half (49%) of the global equity market. In other words, Americans significantly overweighted the US market, leaving them relatively underexposed to foreign markets such as the United Kingdom, Germany, China, and India.

In fact, it’s not just American investors who view the rest of the world with suspicion! Richard Thaler and Cass Sunstein, who are leading experts on behavioral finance, have written that Swedish investors have an average of 48% of their money in Swedish stocks—despite the fact that Sweden accounts for around 1% of the global economy: “A rational investor in the United States or Japan would invest about 1% of his assets in Swedish stocks. Can it make sense for Swedish investors to invest 48 times more? No.” The Solution: Expand Your Horizons

This is really simple. As we’ve said in previous chapters, you need to diversify broadly, not only in different asset classes but also in different countries. It makes sense to discuss your global asset allocation with a financial advisor. Once you’ve decided on the appropriate percentages to keep at home and abroad, you should write down these figures in your investment success checklist. It’s also important to lay out, in writing, the reasons why you own what you own. That way, you can remind yourself of these reasons whenever a part of your portfolio is underperforming.

The best advisors help you to keep a long-term perspective so you can avoid falling into the common trap of favoring whatever market is in vogue. Harry Markowitz, who has a deep sense of history, told me, “We’ve recently had a long stretch where the US market has been doing better than the European market . . . and emerging markets have had a dry spell. But these things come and go.” By diversifying internationally, you’re not only reducing your overall risk but also increasing your returns. Remember when we talked about the “lost decade” of 2000 through 2009, when the S&P 500 produced an annualized return of only 1.4% a year, including dividends? During that time, international stocks averaged 3.9% a year, while emerging-market stocks returned 16.2% a year. So, for investors who diversified globally, those lost years were just a minor bump in the road.

Mistake 6: Negativity and Loss Aversion Your Brain Wants You to Be Fearful in Times of Turmoil—Don’t Listen to It!

Human beings have a natural tendency to recall negative experiences more vividly than they do positive ones. This is known as “negativity bias.” Back when we were cavemen, this mental bias was really handy. It helped us to remember that fire hurts, that certain berries could poison us, and that it was dumb to pick a fight with a hunter twice your size. Recalling negative experiences can also be pretty helpful in modern times: maybe you forgot that it was your wedding anniversary, spent the next day in the doghouse, and thereby learned never to make that mistake again!

But how does negativity bias affect the way we invest? Thanks for asking! As you know, market corrections and bear markets are regular occurrences. Remember: on average, corrections have occurred about once a year since 1900, and bear markets have occurred about once every three to five years. If you lived through the bear market of 2008–09, you know firsthand how emotionally painful these experiences can be. If, like many investors, you owned funds or stocks that plunged by a third or a half (or more), you’re not likely to forget those negative experiences anytime soon!

Now, you and I both know that the best investors relish corrections and bear markets because that’s when everything goes on sale. By now, I’m sure you remember, Warren Buffett wants to be “greedy when others are fearful,” and Sir John Templeton made his fortune—do you remember? That’s right. At “the point of maximum pessimism.” At this point, I’m guessing that your rational mind knows that market crashes are a wonderful opportunity to build long-term wealth, not something to fear! But negativity bias makes it hard for the average investor to act on this knowledge.

Why? Because in the midst of market turmoil, our brains are wired to bombard us with memories of those negative experiences. In fact, there’s a part of the brain—the amygdala—that acts as a biological alarm system, flooding the body with fear signals when we’re losing money! Even a minor market correction is liable to trigger our negative memories, causing many investors to overreact because they’re afraid that the correction could turn into a crash. During a bear market, this fear reflex goes into overdrive, making investors anxious that the market will never recover!

To make matters worse, the psychologists Daniel Kahneman and Amos Tversky also demonstrated that financial losses cause people twice as much pain as the pleasure they receive from financial gains. The term used to describe this mental phenomenon is “loss aversion.”

The trouble is, losing money causes investors so much pain that they tend to act irrationally just to avoid this possibility! For example, when the market is plunging, many people sell their battered investments and go to cash at exactly the wrong moment—instead of snapping up bargains at once-in-a-lifetime prices.

One reason why the best investors are so successful is that they override this natural tendency to be fearful during periods of market turmoil. Take Howard Marks. In the last 15 weeks of 2008, when financial markets were imploding, he told me that his team at Oaktree Capital Management invested about $500 million a week in distressed debt. That’s right! They invested half a billion dollars a week for 15 straight weeks during a time when many thought the end times had arrived! “It was obvious that everybody was suicidal,” Howard told me. “In general, that’s a good time to buy.” By focusing calmly on this bargain-hunting opportunity, Howard and his teammates made billions of dollars in profits when winter ended and spring began. This would never have been possible if they had succumbed to fear!

The Solution: Preparation Is Key

By failing to prepare, you are preparing to fail.

—BENJAMIN FRANKLIN

First of all, it’s important to be self-aware. Once we know that we’re vulnerable to negativity bias and loss aversion, we can counter these psychological tendencies. After all, you can’t change something if you’re not aware of it! But what specific measures can you take so that fear won’t knock you off course even in the most tumultuous times?

As we discussed in chapter 7, Peter Mallouk had tremendous success in helping his clients navigate the global financial crisis. One reason: He educated them in advance about the risks of a bear market, so it wasn’t as surprising or scary when it actually occurred. For example, he explained how each asset class had performed in previous bear markets, so they were prepared mentally for what could happen.

They also knew in advance that Peter planned to use this turmoil to their advantage, selling conservative investments such as bonds and deploying the proceeds to buy more stocks at bargain prices. “We provided certainty about the process,” says Peter, “so they knew exactly what to expect. This dramatically reduced their uncertainty.” In other words, the single best way to handle market turmoil—and the fears it can trigger—is to be prepared for it.

As we’ve discussed at length, one critical way to prepare is to have the right asset allocation. It also helps to write down your reasons for investing in each of the assets in your portfolio, since inevitably there will be times a particular asset class or investment performs poorly, sometimes for several years. Many investors lose faith because they’re so focused on the short term. But when the going gets tough, you’ll be able to look over these notes and remind yourself why you own each asset and how it serves your long-term goals.

This simple process can take a lot of the heat and emotion out of investing. As long as your needs haven’t changed and your assets are still aligned with your goals, you can sit tight and give your investments the time they need to prove their value.

It also helps immeasurably to have a financial advisor who can talk you through your fears and concerns during the most difficult times, reminding you that the strategy you agreed upon in writing when you were calm and unemotional is still valid.

It’s a bit like flying a plane through a really rough storm. Most pilots would be just fine if they were flying solo. But it’s a whole lot easier when you know that you’ve got an experienced copilot in the seat beside you! Remember: even Warren Buffett has a partner.

MASTERING YOUR MIND

Now that you’re aware of these destructive psychological patterns, you’re much better positioned to guard against them. Given that we’re human beings, we’re bound to trip up from time to time. After all, the biases we’ve discussed in this chapter are part of our ancient survival software, so we can’t expect to eliminate them totally. But as Guy Spier says, “This isn’t about getting a perfect score. Even small improvements in our behavior can deliver enormous rewards.” Why? Because investing is a game of inches. If your returns improve by, say, 2 or 3 percentage points a year, the cumulative impact over decades is astounding, thanks to the power of compounding. The systematic solutions we’ve discussed in this chapter will go a very long way, helping you to avoid—or minimize—the most expensive mistakes that the majority of investors make.

For example, these simple rules and procedures will make it easier for you to invest for the long term; to trade less; to lower your investment fees and transaction costs; to be more open to views that differ from your own; to reduce risk by diversifying globally; and to control the fears that could otherwise derail you during bear markets. Will you be perfect? No. But will you do better? You bet! And the difference this makes over a lifetime can amount to many millions of dollars!

Now you understand both the mechanics and the psychology of investing. You know what it takes to master your mind so that you can invest successfully over the long term. The knowledge you’ve acquired is priceless, and it can enable you and your family to achieve total financial freedom. So let’s turn to our final chapter and learn how to create real and lasting wealth!