Stop Investing Like a Caveman

Here you are, a survivor of The Great Recession. Well, maybe you aren't exactly thriving financially, but if you're reading this, then at least you have some passing interest in picking up the shards of your formerly robust portfolio and getting back to the business of saving and investing.

This time will be different. Really, it will. On this go-round, you're going to be a smarter investor -- one who doesn't fall prey to the psychological traps that lead the average investor financially astray.

What's Wrong With Survival Tactics?

The human brain is hard-wired to survive in the wild. Unfortunately, our caveman instincts just don't cut it when it comes to making smart investing decisions.

That's right. The things that keep us out of harm's way -- our drive to seek more and more information, to look for patterns, to compare options, and even to flee to safety -- become a liability when applied to our portfolios.

Warren Buffett agrees: "Success in investing doesn't correlate with IQ ... what you need is the temperament to control the urges that get other people into trouble in investing."

How to Overcome Your Brain Blunders

With a little know-how, you can tame your gray matter and neutralize the psychological noise that leads to bad investing decisions. Better yet, you can prevent a few gray hairs and sleepless nights. So here are a few of the major cognitive biases and some ideas on how to sidestep their devastating forces.

The problem: Hindsight bias. Admit it. You knew the market was going to tank. Hey, so did I! (Ahem.) Through the wonderfully deceptive gift of hindsight bias, past events appear to be much more predictable than they were in real time. The real kicker is that when we look back, we actually believe that we knew what would happen before it did.

The cure: Stop guessing. None of us can predict when the market is going to turn, so stop trying to time it. Instead, focus on your circle of competence. Analyze the businesses in your portfolio, look at how they're faring the current market, and see whether the fundamentals that initially attracted you remain.

The problem: Myopic loss aversion. When things go swimmingly, it's easier to think long-term. But when we're terrified of losing money, our time horizons shrink dramatically. We no longer project what will happen to the business over the next three to five years. Instead, we focus on what happens to the stock price over the next three to five minutes. Think you're immune? Then consider this: When's the last time you simply forgot to check in on your portfolio? OK, when's the last time you checked it just twice a day?

The cure: Go long. At The Motley Fool, we don't measure investing success in minutes or even months. We pick our investments for their long-term potential. If you think like a short-term trader, then you'll be tempted to start acting like one. And right now, nothing could be worse for your sanity and your savings.

The problem: Social proof/herd mentality. It's easy to assume that when the market drops by 10% in a week, "it" knows something we don't. That assumption gains credence as others presume the same. Robert Cialdini, author of Influence: The Psychology of Persuasion, explains how this pile-on takes place: "The greater the number of people who find an idea correct, the more the idea will be correct." So everyone starts selling in a panic -- "the market is going down, and I want out first!"

The cure: Ignore "them." Like your mother said, just because everyone else is jumping off a bridge, that doesn't mean you should. Instead, stick to your plan. Invest on a schedule, and tune out the crowd. While everyone else is trying to game the system, you should be on the lookout for any opportunity to buy great businesses with strong balance sheets on sale.

The problem: Anchoring. Focusing solely on a number is one of the most dangerous mental hiccups for investors -- and lately, we've been drowning in a sea of numbers, from stock prices to market indices and beyond. Suppose we go to a used-car dealership and find a car priced at $7,000 and return later that afternoon to find that it's been marked up to $9,000. Nine grand strikes us as too expensive, even though we know nothing about the vehicle's actual value. However, had we first seen the car priced at $11,250 and talked the salesperson down to $9,000, our mind would tell us that we were getting a great deal. The car is downright cheap! In both cases, we anchored on a number -- a completely arbitrary number.

The cure: Anchor on value, not price. Anchoring is devastating in investing terms. Remember, a stock isn't cheap because it was more expensive yesterday or even last year. So rather than anchor on price, anchor on value. Do your research and determine the price you're willing to pay for the company's future earnings stream before you look at the stock price.

No, You're Not a Hypochondriac

Did any, or maybe all, of our mind-game scenarios seem uncomfortably familiar? That's OK. Even the best investors in the world are victims of the most basic cognitive biases.

The great Warren Buffett -- perhaps the most evolved investor on the planet -- has admitted as much several times in his annual letters. His momentary lapse? Good ol' "anchoring."

In the 1980s, Buffett nibbled a bit on Wal-Mart at $23. When the stock went up one-eighth of a point, he waited on the sidelines for it to come back to his original price. His "thumb-sucking" reluctance (Buffett's words) to pay even a little more cost him $10 billion in profits.

That's right -- even Buffett has to work at reining in his caveman brain.

Fool.com writer Dayana Yochim keeps her cavewoman brain in check by instituting a waiting period before all major money decisions.