Mellody Hobson talks about the psychology of money.


I’m no therapist, but I know money, and it’s really interesting that we can look at people’s behavior patterns and see pretty clearly that psychology plays no small role in people’s investment decisions. The danger is that it can lead to severe missteps that end up costing people countless dollars.

How does that happen? Do you have an example?
The most common mistake we see when people allow their heads to rule their pocketbooks is giving into FEAR. Fear is without question the primary culprit when it comes to emotions getting in the way of sound financial decisions.

Can you elaborate on that a little?
Absolutely. A certain degree of what psychologists call “risk aversion” is good. It’s risky to jump off a cliff, so most people choose not to do it and avoid serious injury.  That’s true of money decisions as well: It’s risky to put your entire retirement nest egg into one stock. Just like in life, a healthy amount of trepidation is wise when it comes to managing your money.

Unfortunately, what we see more often is people overwrought with fear. No one wants to lose their money—it’s a very scary prospect—so a common mistake is to play to too safe. The irony is that you end up LOSING money if you play it too safe.

How do you mean?
The national average on savings accounts is about 0.2% right now. Zero point two! That is NOTHING. You may as well pay the bank to keep your money there, because that’s basically what you’re doing. Inflation is about 2% right now, but historically it’s around 3%. Either way, zero point two doesn’t begin to keep up with it, much less outpace it.

So knowing this is a losing game, say you decide to put $1,000 into a savings account. For this example, I’ll even pretend that savings rates rebound and they just barely keep pace with inflation at 3%. After 30 years, that $1,000 will be about $2,500. On the other hand, if you took on more risk and invested that $1,000 in the stock market, after 30 years, assuming an average return of 10%, it will be worth nearly $20,000. That’s a difference of $17,500!

Since it’s inception in 1926, small and large company stocks have returned over 10% a year.  For long-term savings, it’s a complete no-brainer.

And you know what’s even more compelling? People who have learned to control their emotions can be the best investors. Take Warren Buffett—one of the most successful investors in history—he’s taken this concept to an entirely different level. His mantra is to “be greedy when others are fearful and fearful when others are greedy.” Buffett made his fortune by being a “contrarian investor.” He went against the grain and bought companies with depressed stock prices, searching for untapped long-term value in the “ugly duckling” stocks that no one else wanted to buy. Conversely, during the tech bubble of the 1990s, his company Berkshire Hathaway did not invest in a single technology stock. The reason, Buffett said, was that he avoided the entire technology sector because he didn’t understand the company business models and couldn’t predict earnings. That “invest in what you know” rule is something we can discuss another time, but what’s relevant to our topic today is that Buffett wasn’t swayed by group think; He let people call him a dinosaur and sat out the tech craze, saving himself a lot of money in the process

Of course, Warren Buffett is a masterful investor and we can’t all be as successful with a contrarian investment plan, but we can definitely take a page from his book and be wary of crowd behavior when it comes to investing.

 

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