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5 brain flaws that make you a lousy investor

Max Kabakov | iStock| Getty Images

You're a great investor. Yeah, sure you are. So why are you constantly lagging the Standard & Poor's 500 or afraid to look at your brokerage account statements?

If you are a lousy investor, the problem isn't your stock research skills, ability to read financial statements or even the commissions you're paying, says Joe Huber of Huber Capital Management, which has $5 billion in assets under management. It's your brain.

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Human minds are hardwired with traits that might serve us well when trying to survive, but are detrimental when attempting to make wise investment decisions. Huber lists the way your brain is killing your portfolio, including:

Trading bias. The kind of investor you are can greatly taint your ability to succeed at investing. Bargain-hunting investors, looking for stock deals, tend to buy stocks too early, Huber says. But right when the stocks start to get cooking, and real gains are yet to come, these value investors sell too early, leaving gains on the table. Similarly, growth investors looking for the next big thing often buy too late, once stocks have already rocketed higher, he says. These growth investors might enjoy some of the stock's ride up, but then hold on too long and let those gains slip away.

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Huber's chart below illustrates how growth and value investors miss out on gains by making two timing mistakes:

Source: Huber Capital Management

Recency effect. Investors often make the costly mistake of thinking what's going on now will continue, and that somehow the present is a harbinger for the future. In investing, investors think companies performing poorly now will continue to struggle, Huber says. And the same error in thinking leads investors to think that companies that are doing well will keep doing well. Huber calls this faulty thinking "distorted ROE reversion."

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Such errors can be costly. This isn't Huber's example, but it's a good one: Lululemon (LULU). The athletic apparel company was putting up huge revenue and profit growth. Investors assumed this would continue. These bets on Lululemon proved very costly … and wrong.

The breakdown in Lululemon's growth is staggering, easily seen in a chart:

12 months ended period
Revenue growth
Normalized earnings growth
Jan. 30, 2011 57.10% 107.70%
Jan. 29, 2012 40.60% 59.20%
Feb. 3, 2013 36.90% 31.90%
Feb. 2, 2014 16.10% 9.10%
4-May-14 14% 7.00%
Source: S&P Capital IQ, USA TODAY research

Sunk cost fallacy. "It will come back" are some of the most dangerous words in investors' vocabulary. Investors can't bear with the idea they made a mistake in choosing a stock. So when a stock falls, they often double down on it thinking that will cause them to make up their losses that much more quickly. The trouble is that investors are often better off cutting their losses and moving on, Huber says.

Investors in Whole Foods (WFM) learned this lesson the hard way. At the beginning of the year, it looked like the organic food seller's shares would bounce back. Investors, though, that doubled down lost about half their investment as bad went to worse.

Source: USA Today

Overconfidence effect. The current bull market is leading many younger investors into a false sense of security. Rather than recognizing that rising stocks are lifting nearly everyone's portfolios, investors suffering from the overconfidence effect think their gains are due to skill. Such overconfidence leads investors to pile into risky areas of the stock market, since the investors think they'll know when to bail out. Yeah, right.

Again, this isn't Huber's example, but social media stocks are a classic example in 2014. Despite warnings that many of the stocks were overvalued, some investors piled into them thinking they would know when to get out.

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But it's been a bloody year for most social media stocks and many investors who thought they were investment aces have suffered big losses as a result.

Social Media Stocks

Company
Symbol
2013 $ Ch.
2014 YTD % Ch
Twitter TWTR N/A -40.3
LinkedIn LNKD 88.8% -22.7%
Angie's List ANGI 26.4% -20.2%
Zynga ZNGA 61% -18.9%
Yelp YELP 265.8% 6.6%
Facebook FB 105% 17.5%
Source: S&P Capital IQ, USA TODAY

Prospect theory or "framing." If investors lose 10% in the market they're much more upset than they are happy if they gain 10% in the market. The lopsided reaction to positive and negative information leads investors to make faulty conclusion about decisions and market movements, Huber says.

Clearly, you can't blame all your investment foibles on your brain. But Huber says that these behavioral blunders lead to the most costly mistakes that investors tend to make over and over again.

By Matt Krantz, USA Today

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