10 laws of building wealth: 1. Know the enemy - MoneySense

10 laws of building wealth: 1. Know the enemy

Want to get rich? MoneySense has compiled the best of recent behavioral finance research (and some time-honored financial wisdom) into 10 Laws of Building Wealth.


Know the enemy | Talk to yourself |  Start saving |  Don’t be too smart |  Get over it |  Know your edge |  Be scattered |  Sweat the small stuff |  Be a couch potato |  Sex works

Most of us figure that our biggest challenges when it comes to amassing money are unpredictable markets, inadequate paycheques, and the like. In fact, those obstacles shrink in comparison to the real foe — yourself. That's right. When it comes to amassing wealth, your mind will bewitch you and mislead you. It can cost you a fortune — and may already have done so. DALBAR, a Boston research group, tracked the behavior of investors in the U.S. from 1984 though 2000. The stock market surged by 16% a year during this period. However, the average investor in a stock fund earned only about 5%. The huge gap between what the market produced and what investors actually got was mostly the result of people's habit of jumping in and out of funds, chasing whatever was hot. By pursuing the crowd, investors lost two-thirds of the profits they could have had. Our sheep-like tendency to follow the crowd is just one way in which our minds mislead us. We're far less rational than we think when it comes to money, according to Richard Thaler at the University of Chicago, Daniel Kahneman at Princeton University and many other researchers in the field of behavioral finance. Their work shows that, among other things, we put too much emphasis on whatever has happened most recently. (The "recency" effect is why everyone was buying dot.com stocks in 1999 and may be why everyone is jumping into the real estate market now.) We hate to admit our mistakes, so we stick to lost causes past the point of reason. (If you're still holding on to that Nortel stock you bought back in 2000, you know what I mean.) And we suffer from confirmation bias, which is a scientist's way of saying that we want to talk only to people who agree with us. (So if you don't like what I'm saying, please go away...just kidding.) If you read this list of psychological tics and thought to yourself, boy, other people sure do silly things, but thankfully you don't — think again. You're suffering from overconfidence. It's by far the most psychological illusion and it's a brutally hard habit to break. Researchers have shown that nearly all of us are overconfident, sometimes to the point of comedy. Eighty percent of students predict they will finish in the top half of their class. Seventy-five percent of mutual fund managers think they are above average at their jobs. Almost 90% of us think we're better than the typical driver. The more you know, the more likely you are to overestimate your ability to predict the future. Philip Tetlock, a professor of political science at Berkeley, spent years surveying the views of top political scientists and analysts on world events and found that these supposed geniuses were usually wrong even when they were most confident. On predictions in which they indicated they had 80% or more confidence, they were correct only 45% of the time. Overall, they had no more ability to forecast the future than a coin flip. The moral? Be humble, be willing to admit mistakes, and be willing to change your mind. In the pursuit of wealth, "don't get hung up on one technique, tool, approach or view," writes James Montier, global equity strategist at Dresdner Kleinwort Wasserstein in London and author of many papers on the psychology of investing. "Flexibility and pragmatism are the order of the day."