Friday, November 16, 2007

A Third Investing Pitfall: Overconfidence

So you’ve been investing for a while, know some buzz-words, and now you’re a financial whiz. It’s time to start trading in and out of speculative stocks and stock options to make big money.

Hold it right there! This could be a disaster. You could lose most of your money very quickly. There is nothing wrong with investing in individual stocks if you are truly knowledgeable and willing to put in the time to follow the companies you own. Following a stock price is not the same as following the company. If you own an individual stock you should have an informed opinion about the company’s prospects and whether the current stock price is high or low relative to those prospects. This is not true of the average investor. Be wary of overconfidence. You may be better off sticking with the unexciting and low-action index fund strategy.

Overconfidence can creep in slowly. It might begin with thinking that you can predict a period of dropping stock market prices, and so you sell some of your index fund and put it in a bond with the plan to switch back later. It is true that there are some people who do this successfully. Some of these people might actually be skilled rather than just lucky. However, there is strong evidence that most investors do not make good market-timing choices, and the result is higher trading costs and poorer investment performance than if they had just left things alone.

If you can avoid the potential pitfalls of taking control of your investments and buying index funds, you will get better returns than most people who invest in high cost mutual funds with financial advisors.

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