COMMON INVESTMENT MISTAKES - CAN YOU BEAT A RAT?

One of the most common investment mistakes is that of prediction. We often believe that we see a pattern, even if there is none. Even worse, in the face of statistical data we often try to beat the system in some way.

Key points:

  • A study shows that rats beat humans when it comes to prediction
  • We can apply this to common investment mistakes
  • Watch the explanatory video on the common investment mistakes amateurs make

An example of this is shown by this article in the New York Times, which discussed a study of rats. Each rat was shown 2 lights, red and green. The green light would come on 80% of the time, and the red light 20% of the time, in a random manner. If the rat pressed the correct button corresponding to the light flashing, they would get a reward. The rats quickly deduced the bias towards green and simply pressed the green button every time. As a result they consistently achieved an 80% success rate in the tests. Obviously, any better than 80% would mean some sort of magical powers!

The same test was conducted on human subjects. The people involved often tried to seek a pattern in the lights, and even when told that the pattern was random would score no better than 64% in the tests. The rats beat the humans by 16%.

This reflects the common investment mistakes that many amateur investors make. They try to predict the investment market, when really they are looking at the short-term rather than long term data. If they were to take a dispassionate view, like the rats, they would realise that to maximise thier success they should avoid trying to predict the investment market.

Different studies of investments show the results of these common investment mistakes in humans. It has been said that amateur investors consistently under perform the average of the investment market by as much as 6% per year – simply by making mistakes and compounding them.

So how do you avoid these common investment mistakes?

One way to avoid common investment mistakes is to stop trying to time your entry into the market. You can also diversify some investment risk by spreading your assets into different types of assets and geographical regions.

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