Step One: The Difference Between Saving and Investing

This chapter offers a look at the thinking that damaged so many retirement portfolios: misunderstanding what saving is and where it should be used and what investing is. This section begins the conversation about what makes a good investor good: how they use the information available to them and when to react to it.

Why Investors Do What They Do

Loss Aversion (Book excerpt)

While risk and uncertainty have their place in the investment world, how people react under those conditions was the subject of a paper done by noted psychologists Kahneman and Tversky titled the Prospect Theory. They realized that “since loses loom larger than gains, it appears that humans follow conservative strategies when presented with a positively framed dilemma, and risky strategies when presented with negatively-framed ones.” They also noted that numerous influences enter into the equation including normal behavior, habits the investor might already have and the personal characteristics of the decision maker. Preorder the book Target2025.

Narrow Framing (Book excerpt)

Obviously, the easiest measure of wealth is more tangible elements such as what you get paid (human capital) which also includes what you may have saved (not invested) and the worth of your real assets, such as your home. Once you commit a certain portion of either of those two assets to the investment of your choice, you begin to open the door to regret. Preorder the book Target 2025.

Anchoring (Book excerpt)

Unfortunately, anchoring is a bias. It is often included among other similar cognitive biases such as memory bias (which effects how we recall a situation after the fact) and confirmation bias (depends largely of what you already know and uses this information to skew your perception of what really is). Each alters what we see with something we already know. Preorder the book Target 2025.

Mental Accounting (Book excerpt)

Many of us can rattle off the balance in our set-aside accounts, the small stashes of money we allot for some special purpose. These accounts, whether they be for a down payment on a house or a vacation have been designated for something and when you mentally account for this money, you put a barrier around your access to it. Preorder the book Target 2025.

Diversification (Book excerpt)

But what is often overlooked is that not only do you decrease your chances of being wrong, you by default increase your chances of being right. Diversification will spread the risk and as a result of that, may allow you to miss the next hot stock or mutual fund. Because it is impossible to pick the future based on the past – recall the reminder that past performance might not play a role in future results – diversification makes the chances of getting some of the hot property but not all of it. Preorder the book Target 2025.

Herding (Book excerpt)

In Emilio Barucci’s book “Financial Markets Theory” he describes herding as an “effect [that] arises because other decision makers may have information important for the decision maker”. He points out that “fund managers care for their performance because their compensation, their career and the probability of being chosen in the future by investors depend on their performance relative to an exogenous benchmark or to the performance of other fund managers.” He notes that the presences of these features, while not saying competition is bad, results in investor herding. Preorder the book Target 2025.

Regret (Book excerpt)

We are at an investment point in time where we are (if not already have been) subject to regret in doses much larger than we have experienced before. These reactions and the rationale you may have used to make your decision was based on minimizing your risk for a situation that may well have passed. Preorder the book Target 2025.

The Media (Book excerpt)

It is as they say, much easier to swim with the tide. And many traders are now focused on doing just that, predicting when their colleagues, other investors all begin to believe something is worth more than they know it should be worth. Preorder the book Target 2025.

Investor Optimism (Book excerpt)

Asking questions such as whether you will be able to achieve your investment targets over the next twelve months requires you to know what those goals were over the previous twelve months and during that period, you switched gears (and how many times). Preorder the book Target 2025.

Previous Books by Paul Petillo

Hardcopy: Mutual Funds for the Utterly Confused (McGraw-Hill, 2008), Retirement Planning for the Utterly Confused (McGraw-Hill. 2007), Investing for the Utterly Confused (McGraw-Hill, 2006), Building Wealth in a Paycheck-to-Paycheck World (McGraw-Hill, 2004)

eBook: Mutual Funds for the Utterly Confused (McGraw-Hill, 2008), Retirement Planning for the Utterly Confused (McGraw-Hill, 2007), Investing for the Utterly Confused (McGraw-Hill, 2006), Building Wealth in a Paycheck-to-Paycheck World (McGraw-Hill, 2004)