Are Emotions Ruining Your Investment Returns?

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Money is fraught with emotional baggage. However, all of the external influences that affect our fiscal decisions -- how mom and dad managed family money, the daily headlines warning of pending doom -- are nothing compared to the naturally occurring power struggle taking place in our brains.

That's right: One of the biggest stumbling blocks to financial security and superior investment returns is the way we're wired. But with self-awareness and a few practical tips, you can tame your gray matter and neutralize the emotional tripwires in your head.

Rein in Your Caveman Brain
For eons, our brain chemistry was just peachy at keeping us out of harm's way -- to seek more and more data or information, to look for patterns, to flee to safety at the first sign of trouble. Unfortunately, those same natural instincts compel modern-day man (and woman) to make boneheaded mistakes when it comes to managing our finances.

Here are four "cognitive biases," to use the language of behavioral economists, and ways to spot mind games before they get the better of you.

1. "Eek! I Gotta Sell Now!" Being a bona fide long-term investor is easy ... until it's not. When things go well, we're content to keep our eye on the long-term prize. When bad news comes -- and keeps flooding in -- our time horizons shrink dramatically. Investing is then no longer about what happens during the next three to five years. Instead, we focus on what happens over the next three to five minutes.

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The technical term for this compunction to cut our losses when the waters get choppy is myopic loss aversion. When you start thinking like a short-term trader, you start acting like one.

Hard times can be learning opportunities, which is a lot more productive than curling up in the fetal position and rocking back and forth for hours. When the urge to cut and run strikes, remind yourself that investing success is not measured in minutes or even months. Before you even invest in a company, write down your reasons for buying -- and things that would make you sell (such as a change in management or a particular product that falls out of favor). That way, when the ebbs and flows start ebbing and flowing, you have a record of your thinking from when your mind was calm and you were thinking long term.

2. 'I Can't Turn Off the TV; I'll Miss Something Important!" With stock market news dominating every major outlet, we're bombarded with information -- and we keep watching because we just can't seem to get enough. Watching the market's conniptions and CNBC pundits' breathless banter simply makes the situation seem more dire.

When you find it hard to tear yourself away, set a timer (five minutes of rubbernecking is adequate) and jot down what it is that you're hearing/reading that you think is going to help you make better buy or sell decisions. When the alarm sounds, go make yourself a sandwich and review your notes. What you'll discover is that most of the "information" bombarding your senses isn't even relevant to the real decisions you need to make.

3. "They Must Know Something I Don't." It's easy to assume that when the market drops 18% over the course of the week, "they" know something we don't. That assumption gains credence as others presume the same. Cue "herd mentality" (or "social proof") -- which leads to mass sell-offs.

Instead of following the crowd, look for ways to make money from their panic attacks. While everyone else is trying to game the system, you should be on the lookout for the opportunity to buy great businesses, with strong balance sheets, on sale.

4. "What a Great Deal! I Saved $1,000!" Suppose you go to a used-car dealership and find a car priced at $8,000. You return later that afternoon to find that it has been marked up to $10,000. Ten grand strikes you as too expensive, even though you know nothing about the actual value of the vehicle. However, had you first seen the car priced at $12,250 and talked the salesperson down to $10,000, your mind would tell you that you were getting a great deal. The car is downright cheap! In both cases you "anchored" on a number -- a completely arbitrary number.

Anchoring is devastating in investing terms. Think about it: A stock isn't "cheap" because it was more expensive yesterday or even last year. You have to have a sense of its true value before you can make a smart investment decision.

Rather than anchoring on price, anchor on value. Do your research and determine the price you're willing to pay for the company's future earnings stream before you look at the stock price.

What mental hiccups have gotten in your way as an investor? Chime in below, and tell us what you do to make sure mind games don't get the best of you.

Dayana Yochim is a columnist for The Motley Fool and does not blame her mother for any of her own investing mistakes.
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