The Cost of Being Human
Why do we so often buy high (the internet bubble of 2000) and sell low (2008-2009), when doing just the opposite is the only way to succeed? Why do so many of us make so many bad investment decisions?
Because we’re programmed to.
Our genetic code is our enemy when we make investment decisions. The behaviors and biases that hurt our portfolios are innate. We’re simply born this way. After all, would we ever logically and willfully make an investment decision that loses money? Of course not.
Here’s a brief description of some of the behaviors and biases that we must overcome to be successful investors.
OVERCONFIDENCE – “I’m awesome at investing. No, really.”
We tend to believe we’re great investors, despite the results. Studies show that our belief in our ability to predict investment outcomes far outweighs our actual ability.
ANCHORING – “I hate being wrong.”
We ignore new information that will discredit the rationale behind our original decision.
DISPOSITION EFFECT – “I refuse to lose money.”
We are reluctant to accept losses. This explains why we hold on to bad investments, or even worse, pour more money into them.
FRAME DEPENDENCE – “Wait! I’ve changed my mind.”
We tend to change our tolerance for risk based on the direction of the market, when it should be based on our time horizon and our need to take risk. Buying high and selling low is a common, and unfortunate, outcome.
RECENCY BIAS – “The market’s going down!”
We give recent information greater weight than the long-term evidence warrants. Have you ever felt that “the market is never going up”? Perhaps during the crash of 2008? You’re not alone. Yet, up it has gone, as the long-term data suggested it would.
CONFIRMATION BIAS – “I don’t want to hear it.”
We favor evidence that supports our beliefs and decisions, and gloss over that which refutes them. This bias makes an investment process rooted in peer-reviewed science and objectivity essential to success.
GAMBLER’S FALLACY – “I know this stock is going up.”
The human mind seeks patterns and causality in events. We try to make sense of the randomness of markets. Consequently, we make decisions misled by trends that aren’t really there.
HERD MENTALITY – “But everyone else is doing it!”
Our ancient ancestors found safety in numbers, and we often feel the urge to run with the herd. This is another bias that has us selling at the low, when everyone else is selling, and vice versa.
The role of discipline and objectivity in investing should be evident. We must battle our instincts in hopes of finding success in our investing. It’s not easy. And it’s OK to ask for help.
John & Bill