April 28, 2008


Three key components are often mentioned when discussing the accumulation of wealth: savings consistency, time horizon, and cost control. For young savers, the rate of return (what most people focus on) is much less important than developing a consistent savings plan. Investing regularly in a prudent selection of mutual funds will build wealth faster than any other strategy. With time on your side, you can afford to make some mistakes without much long-term damage. The biggest mistake made early on [which you can't afford to make] is simply not to save.

Behavioral finance is the academic field studying how psychology influences an investor's decision-making process. Some interesting findings have surfaced ...

- People tend to be more optimistic about stocks after the market goes up and more pessimistic after it goes down (opposite the fear/greed sentiment Warren Buffett and others suggest).

- Investors give too much weight to recent information and too little weight to long-term fundamentals.

- People tend to chase recent performance (over 80% of new mutual fund purchases go into the funds that have the best one-year return); consistently shown to be a faulty approach.

- Investors typically consider the loss of $1 twice as painful as the pleasure from a $1 gain.

- People are reluctant to admit mistakes in judgment. For some, this means hanging on to stocks or funds that should be sold; for others, it leads to paying high commissions and fees to brokers and advisors so they have someone else to blame.

- Women tend to have a longer term view of the markets than men. They maintain an investment plan longer, and as a result they generally perform better.

Ultimately, the key to building wealth is making rational decisions and having the discipline to maintain those decisions. Unfortunately, we tend to become quite irrational when it comes to financial decisions. Successful investors understand the limitations of the markets as well as their own personal limitations and develop a plan that accommodates both.

A plethora of behavioral finance information and studies can be found at: http://www.behaviouralfinance.net.