6 Mental Money Mistakes, and How to Avoid Them

The human mind is a wonderful, incredible thing. It’s more powerful than any computer on the planet (at least, right now, but that’s another subject), capable of performing numerous calculations at once. It can maintain our heart, monitor our breathing, handle the functions of our other organs, and still have enough neurons let over to let us debate what to eat for dinner. It is a truly remarkable thing.

It is not, however, perfect. There are sadly many mistakes that our minds make, particularly when it comes to the subject of money. Money, and especially things like investing, are a relatively recent innovation in human history, and our brains have yet to adapt to the best way to handle the cash we have available. As a result, many times our instincts about how to handle money situations are the exact opposite of what we should do. There’s quite a few mistakes that people make, but today we’re focusing on just:

Six Mental Money Mistakes and How to Avoid Them

1. Selling Your Winnings Too Early…: It’s a pretty common thing. You’ve bought a stock and it’s gone up in value. (It doesn’t have to be a stock, it could be another investment; I’m just going to refer to ‘stocks’ throughout this entry, to simplify matters.) It’s increased 10%, 30%, 50%, or maybe even doubled in value. You feel great, because your stock picking skills have been rewarded. If you find yourself needing money at this point, you have no trouble selling this stock and locking in your profits. That’s the smart move, right?

Not necessarily. While it’s good you’ve gotten a profit from your investment, you might be missing out on an even higher profit if you held onto the stock longer. The doubling might have been followed up by tripling, quadrupling, or even a ten-fold increase. Peter Lynch even created a new term, the ‘ten (or whatever multiple of the initial price) bagger’, to describe such a large price increase. By selling the stock, even when it rose in price, you might have denied yourself an even higher increase in price and the corresponding profit possible.

How to Avoid It: When you’re considering selling your stocks, you have to ignore the price that you paid for them and just look at where the stock is likely to head from that point on. If you are sure it’s gone as high as it will go, by all means sell it, but if there is potential for the price to climb even higher, you should hold onto it until it’s run its course (and possibly buy more). Should you need to sell something, perhaps you should check out your losers…

2. …And Letting the Losers Ride Too Long: On the other side of the coin, you’re probably not too eager to sell your stocks that have gone down in value. The ones that have lost 10%, 30%, or even 50% of their value are the last ones you want to sell. Doing so would mean turning a paper loss into a ‘real’ loss, proving that the investment was a bad one and forcing you to acknowledge the loss.

The problem is that as long as your stock still has value, it can lose even more of that value in the future. You can find it dropping even further in value, down to zero in some cases, and not selling means that you’ve lost the last of the value of your stock. Holding your stock until they’re back to even, or making a profit, can lose you even more money than you’ve already lost.

How to Avoid It: As with your winners, when you’re considering selling your losers, you have to evaluate them not on the basis of what you purchased them at, but how much they are worth now compared to where they are going. If they are, by your estimates, going up, keep them, but if they show no signs of improving, sell them while you still will get some money back. (Also, you might want to consider a stop-loss order when purchasing your stocks, to keep them from dropping too much in value before they are sold, to limit your losses and prevent these kinds of situations.)

3. Following the Herd: Let’s be honest, most herd animals aren’t terribly intelligent. They will follow the herd regardless of where it is going. Whether the herd is heading to safety while running from a predator or being ‘herded’ into a processing plant, they won’t stop and evaluate the situation and make a decision on their own, even it not doing so leads to bad results for them.

Unfortunately, humans can behave in the same way, particularly when it comes to money. When lots of other people are buying a particular type of investment, be it technology stocks during the tech boom or real estate during the recent bubble, we assume that other people know what they are doing and do the same thing. As a result, when the bubble bursts, we find ourselves holding investments we paid too much to buy and can only sell for a fraction of the price. We might not be slaughtered, but it can slaughter our net worth.

How to Avoid It: Considering investments on their own basis can help you determine if they are undergoing a bubble. If the price on a particular type of stock is rising much faster than normal, and indicators like the P/E ratio are getting way out touch with their typical values, it’s likely that a bubble is starting to form. Ignore traditional wisdom and buy safer, more traditional investments. You might not have good cocktail stories about quick profits, but you also won’t have horror tales about losing half your cash when the hot stocks take a tumble.

4. Being Overconfident: Do you think you’re above average in money management skills? How about investing? What about more everyday skills, like driving? You’re probably a pretty skilled person, after all; do you think that you would rank above 50% of the general population in any of these skills?

If so, you’re not alone; it turns out that ALL people rank themselves above average themselves as above average drivers in a Canadian study, and that’s not the only one. Most people consider themselves as better than the typical driver out on the road, even though it’s mathematically impossible for everyone to be better than average (if they were, the average would be much higher, and there would presumably be fewer accidents).

The same goes for investing. If you think you’re smarter than the average bear (sorry, I couldn’t resist the Yogi joke), or at least the average investor, you’re more likely to engage in investments that are riskier or simply less intelligent than the investments you should choose. If you do so, you can end up losing an above average amount of money and finding yourself with less money than if you tried to match the average and not beat it.

How to Avoid It: In the investing world, it’s good to keep in mind that you are probably not the best investor out there (and that the professionals have impressive levels of computing power and numbers of researchers available, putting you at even more of a disadvantage). In most cases, it’s good to shot for the average with most, if not all, of your investment money by simply using index funds to meet the market average. Yes, you’ll miss the big stock hits, but you’ll also dodge the huge misses. (As for driving, it’s worth remembering that most people on the road consider themselves wonderful drivers, and drive more cautiously as a result.)

5. Ignoring Inflation: Here’s a hypothetical question (yes, yet another one): if you are getting a raise at work, would you prefer a 3% raise or a 10% raise? The 10% one, right? I mean, it’s more than triple the value. How could it be the wrong level of raise to prefer?

Ah, but if the 3% raise is given during a time of 2% inflation and the 10% raise is during 15% inflation, the 3% raise will increase the buying power of your salary more than the 10% raise. Ignoring the power of inflation to affect the real value of your money can lead to numerous mistakes, from not making investments that will stay ahead of inflation (like stocks) to choosing investments that will lose purchasing power over time (like CDs or bank accounts) to, well, considering increases in money, whether from raises or investments, strictly on their nominal values.

How to Avoid It: You have to look at investment gains or potential losses in terms of the spending power of the resulting money, not merely the nominal increase in money. In particular, if you are looking decades in the future, the amount of ‘stuff’ a given amount of money will buy will have decreased substantially. A decent rule of thumb: if inflation is around 3%, a reasonable estimate, you can expect the value of goods and services to double every twenty years. As a result, you need to choose investments that will more than double your amount of money two decades from now, just to stay ahead of inflation, and that means putting a sizable amount of your investment money into ‘risky’ investments like stocks, instead of sticking with ‘safe’ investments like CDs or bank accounts.

6. Viewing Money Differently, Depending on the Source: We have a tendency to mentally divide our money into different ‘pots’. The money we get from work goes into one pot, the money from side jobs (if we have any, which is not a bad idea) goes into another, the money we get as gifts goes into third pot, and the money from a tax return goes yet another pot. We also divide our money up into different pots by use: the mortgage payment in one, the investment money in another, the ‘fun’ money into yet another. This isn’t a bad thing by itself, as there are different sources of money in our life and different needs to meet; we need to make sure that our mortgage gets paid, investments are made, food is purchased, and other regular needs are met.

The problem comes in when money, particularly ‘found’ money (like those gifts or tax returns) is treated as if they can be spent on anything, rather than put towards useful goals like paying down debt or investing. We tend to consider some money as less valuable than other money, particularly when that money is money we don’t need to work to obtain. We’re ‘playing with the house money’, not thinking we should save the money instead of using it for more vital goals. It’s also part of the reason why we spend more with credit cards than we do when we pay cash; if it’s not in front of us at that moment, we value the money less.

How to Avoid It: The key is make the money more ‘real’, and not consider it the house’s money. For credit cards, you need to stop and consider whether you would buy the same thing (and pay the same amount) if you needed to have the cash at that very moment. (You might also want to limit yourself to debit cards, as to keep yourself from spending money you don’t have.) For ‘found’ money, a good idea is to keep it in a bank account for a while, so you start to think of it as, well, regular money, not money you can spend however you wish without consequence.

These are far from the only mental mistakes we make when it comes to money, unfortunately, but they should give you some suggestions on how to avoid even more. Any mistakes you’ve made that you’ve come to regret? Any advice on how to avoid mistakes like these when managing your money?