When it comes to investing, many of us are worried about making mistakes.
After all, your money is on the line and you don’t want to lose any of it. Unfortunately, that very feeling of risk aversion might increase the chances that you make investing mistakes. On the flip side, you are also more prone to mistakes if you are overconfident. Both of these situations can lead to investing mistakes that can cost you big in the long run.
Here are the risks associated with being too risk averse or feeling overconfident:
Investing Mistakes Made by Being Too Risk Averse
One of the biggest issues you’ll run into as a risk averse investor is moving your money into “safer” investments right at the wrong time. Selling your investments during a down market and then putting the money into cash, can cause a couple of problems.
First of all, selling when the market is down leads to locking in investment losses. Next, moving into cash assets means you’re not going to see the same rate of returns. In some cases this risk aversion is compounded by the fact that moving into cash positions doesn’t make sense from a long-term perspective if there haven’t been changes to your spending needs or income interruption with other revenue sources.
Many of the risk averse move into cash when the market goes down, and then decide to buy again when the market starts improving. This is a recipe for selling low and buying high. From a long-term perspective, it often makes more sense to buy more stocks during a down turn because you can get bargain prices and see potentially greater returns during a subsequent recovery.
Take the recent market volatility for example. I know a few guys who were scared of the downturn and moved some money into cash in February, only to see the market zoom back up a good 10% in the last four weeks. The worst part is that these people don’t really track their performances, so they will likely do this over and over again. There’s a reason why we urge everybody to stay the course. Doing nothing is actually not easy, but it’s often the most profitable non-action you can ever take.
Overconfidence Doesn’t Help Either
Another major investing mistake is overconfidence. Those who are overconfident in their abilities tend to trade more. This means that they are more exposed to losses, and chances of losses, because of their frequent trading. On top of the risks that come with trying to time the market or pick winning stocks, overconfidence comes with the cost of trading.
Those who are overconfident are more likely to make frequent trades, and those come with transaction costs. This can further erode your real returns over time as you trade too confidently, and pay the costs.
While you need to do your own research and figure out an investing plan that works best for you, one of the strategies that can help you take advantage of market performance is indexing. I find that indexing works well for me. Because I am investing in broad-based market performance, it reduces the risk associated with stocks (but doesn’t eliminate it). And if I keep my money in for a couple of decades, I am likely to reap the rewards of higher returns that I wouldn’t see in cash products.
Carefully consider your own situation and decide what is likely to work for you while avoiding the mistakes of too much risk aversion and overconfidence.
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