What Differentiates a Good Investor?

Only a few of us are born with investing qualities. Even the greatest investor of all times, Warren Buffet, made a number of mistakes before getting on the right track. The difference between a successful investor and an unsuccessful one is the ability to learn and avoid the mistakes other people have made.

It's no secret that many investors focus obsessively on one investment that's losing money, even if the rest of their portfolio is in the black. This is one of the most famous mistakes, called loss aversion. Like this mistake, many investing mistakes are related to our physiological nature as human beings. Here are two more main behavioral mistakes that you should avoid.

Overconfidence - Overconfidence refers to our boundless ability to think that we're smarter or more capable than we really are. Optimism isn't a bad thing; however, overconfidence can harm you as an investor when you believe that you are more capable of spotting the next Microsoft than another investor. You have to recognize that you are probably not (nothing personal...).

Overconfident investors tend to trade more frequently because they think they know more than the person on the other side of the trade. The commission and tax drawbacks of trading too frequently are the number one factor for shrinking the portfolio of these traders.

To avoid overconfidence in your investing, document and review your investment record over time. It's easy to remember your one stock that gained 50% in a short period, but records may reveal that most of your investments have overall negative returns for the year. Also, even if you're an expert, remember that the investor on the other side of the trade is no less smart than you; always consider the odds that he can be right and you can be wrong.

Anchoring - Ask an American to estimate the population of Spain and they will anchor on the number they know, the population of the U.S., and adjust it down, but not enough. The opposite will also happen if you ask a Spaniard about the population of the U.S. This anchoring will happen to any one of us when trying to estimate things that are unknown.

The same thing happens to many investors. They buy a stock and anchor on the price they paid for it or on the financials of the company when they bought it. As a result, if the stock price went down, even if the company is not attractive any more, they continue holding on to the stock. They anchor on last year's earnings and on the buy price, hoping that the stock will return at least to the point where they bought it. For the most part, it won't happen and the deterioration of the business was translated into price reduction; thus, years could elapse before the stock returns to that point, if at all.

In order to avoid that, ask yourself a simple question: "Based on the current valuation of the company, would I buy this stock now?". If the answer is yes, it is rational to keep it; otherwise, realize that you have lost some money, then sell it and move to other stock. Remember that the loss from this investment can be used to reduce tax payments on other investing gains.

It's easy to recognize these mistakes but harder to avoid them in your investments. The best way to overcome these mistakes is simply by practicing in similar situations. Obviously, it isn't wise to practice in your real investment account so you are encouraged to practice it in stock trading competitions. At the beginning, it is possible that you'll make mistakes in many of the games that you'll participate in. In time, you'll become much more experienced and aware of these behavioral mistakes, and eventually learn to avoid them.

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