Follow these rules for good returns with reasonable risk. Behavioral finance expert Meir Statman says to save, diversify and mind expenses. /kipimages/pages/11749.jpg By Anne Kates Smith, Executive Editor From Kiplinger's Personal Finance, November 2013 Meir Statman is a finance professor at the Leavey School of Business of Santa Clara University and the author of What Investors Really Want: Know What Drives Investor Behavior and Make Smarter Financial Decisions.Kiplinger’s: How should people think about their roles as investors? Statman: Knowing how to invest is really important these days. The old days of pensions are almost gone, and the days when people could earn a decent return by putting money in a savings account at a bank are long gone. People have to make sophisticated decisions about investing if they hope to accumulate enough for retirement and other life goals. But trying to teach them to be sophisticated investors is a waste of time. What’s important is for people to invest in ways that are smart. There are really simple rules that you can follow, if the goal is to get good returns at reasonable risk. For example, diversify. Don’t try to beat the market. Don’t try to time the market. Save regularly. You really don’t need many rules. Sponsored Content Sounds simple. So what trips us up so often? Emotions get in the way. Fear and exuberance are one pair of emotions. Fear causes people to become excessively risk-averse. In 2008 and 2009, people yanked money from the stock market to put it in money market funds and lived to regret it. Exuberance is just as dangerous. In 1999, it led people to concentrate their portfolios in high-flying dot-com stocks. Another emotion is regret. People swayed by regret find it hard to realize losses. They think, I was stupid to buy this fund that went down. If I realize the loss, I’ll feel doubly stupid. Advertisement In addition to emotional mistakes, what are some of the cognitive errors that investors make? Acting on hindsight is a major error. When people look back, they tell themselves that they just knew what was going to happen, and they confuse the ability to forecast the past with the ability to forecast the future. Another error is extrapolation. People tend to extrapolate not recent returns but, rather, vivid returns. When people ask what’s normal, what comes to mind is not what happened in 2010, 2011 and 2012, but what happened in 2008 and in early 2009. That view of the world prevents people from taking reasonable risks. Our judgment can also be swayed by what is available to us. When we judge the likelihood of something, such as being able to find a mutual fund that will do spectacularly well, we don’t look at the whole sample, or at studies that show that, on average, active fund managers trail index funds. We focus on the money manager who just beat the averages hands down. Mutual funds advertise their five-star funds, not the two-star funds. In our minds, winning funds are amply available, and that makes people think it’s more likely that they’ll be winners themselves. Have you ever seen a lottery commercial in which someone is looking at his number in disgust and saying, “Never again”? No, you see the ones with the giant check, and you think, Why shouldn’t I win? Does knowing how these pitfalls work make it easier to avoid them? You don’t have to study behavioral finance. Academics and investment professionals have studied it. When I go to a physician, I don’t try to duplicate his knowledge. I rely on the fact that he has that knowledge. And what do financial physicians say? They say diversify, save and don’t try to beat the market. In a similar vein, I know I am better off eating vegetables than hamburgers, even if I don’t fully understand the biology involved. Are you saying that investors should not be do-it-yourselfers? They can be do-it-yourself investors, but do-it-yourself investors need not be tinkerer investors. They should not be too-smart-by-half investors. Advertisement Are there products or strategies that can help us overcome some of the behavioral errors we’re prone to? Dollar-cost averaging is a good way of doing something that’s difficult. Say you receive $100,000 from an aunt who passed away. You’re going to be reluctant to invest it because of the fear of regret. What if the market collapses as soon as you buy stock? That would be a hit to your pocketbook, and to your ego. But if you split that $100,000 into ten increments of $10,000 each, and invest each one in the middle of the coming ten months whether the market has gone up or down, that creates a system that mitigates regret and forces self-control. A strategy for when you’re tempted to trade in or out of the market—maybe because you heard some guru on TV—is to take the equivalent of a cold shower, which is what I do. Frame the decision to trade another way. Tell yourself that in every trade there is an idiot, and if you don’t know who that idiot is, it’s likely you. Could the idiot on the other side possibly be Warren Buffett? Or Goldman Sachs? Or a hedge fund with inside information? That’ll cool you down. As for products, my investments are entirely in low-cost index funds. What mistakes are investors making now? Many people are living as if we were still in 2008—and who can blame them? One day it’s the debt-ceiling issue, another day Europe is disintegrating, unemployment is up or interest rates are rising. People are really jumpy because their nerves were shattered. They’re too cautious about investing, like driving too slowly in the right-hand lane. How do you get out of the slow lane? By driving constantly in the middle lane. Don’t try to overtake idiots who pass you too fast, and don’t be a slowpoke. Driving in the middle lane means saving a good chunk of your income, investing in a diversified portfolio—some stocks, some bonds, some cash, some domestic, some international—because you don’t know which will do well. It also means minding expenses, which you can do by investing in low-cost index funds. Don’t change lanes all the time by trading. Advertisement But sometimes you just want to drive fast and change lanes. That is right. For some people, trading is a joy in the same way that tennis or golf is a joy for other people. And while I don’t find trading joyful and I don’t play video games, I can see that some people like to play video games or trade. But again, I would advise people not to spend all their time and all their money on video games or trading. Know that despite what you’re telling yourself, trading is going to cost you money rather than make you money. So if you indulge, indulge in moderation.