With the US stock market experiencing its first significant correction in a couple of years, it seems like a good time to discuss some of the psychological biases that can negatively influence investor behavior:
We all tend to actively seek out information that supports opinions we have already formed and to digest facts which suit our own world view. Investors commonly ignore or avoid reading critical opinions and reports about investments in which they already have large positions and seek confirmation from analysts and the media that the original decisions they made to buy and keep are still good ones. Just as great leaders will listen intently to those with whom they disagree, great investors should listen to the growling bears going in the opposite direction from the thundering herd of bulls.
The price an investor initially pays for a stock can act as an unfortunate psychological “anchor” that can lead to irrational decisions about the future value of the company. A confident investor buys what they think is a great company at a perceived bargain price of $ 100 per share; only to see bad news about the company and economy causing the price to drop to $ 50 during the next two months. The fact that the investor paid $ 100 initially can cause an irrational assessment of the potential of the company at its new price “Great !! I will double my position at this new price! ” In reality, the initial price of $ 100 paid by the investor has nothing to do with the company’s growth potential if purchased at its new price of $ 50, but it is perceived as a cheap price based on the much higher price paid initially.
3. Myopic Loss Aversion
Investors must manage the battle between fear and greed in their heads and stomachs to be successful in accumulating wealth in the long term. Unfortunately, the fear of loss is generally a more powerful force that overwhelms many investors during periods of steep losses in stock prices. Even though they don’t plan to liquidate the investment for decades, many investors panic during corrections and bear markets; causing them to miss out on the often sharp recovery in prices that follows. Warren Buffett has described his legendary approach to value investing in this simple way, “When the herd is greedy, I am fearful, when the herd is fearful, I am greedy.”
4. Playing with the house’s money
Casino operators and professional poker players are very familiar with this behavior. A novice gambler makes a trip to Las Vegas with $ 5,000 in their pocket to gamble. Their decisions on whether to hold’em or fold’em in any given hand can be greatly influenced throughout the night based on whether they have more or less than the initial $ 5,000 in their pocket. If they “win” $ 3,000, they may be more likely to make aggressive bets with the $ 3,000, which is the “house’s money” than they would if they had less than the initial $ 5,000 in their pocket.
Investors often react the same way. Consider two investors: one who purchased $ 100,000 worth of stock in Amazon at $ 30 per share two years ago. The second purchased $ 100,000 worth of stock in Amazon at $ 50 per share today. If the price drops back to $ 40 over the next few months, the first investor may be less likely to sell as they are still playing with some of the “house money.”
This is the “Lake Wobegon” effect. Even though study after study has shown that it is virtually impossible to time the markets and be invested only when prices are going up, many investors overestimate their own abilities. In an effort to feel in control and “in the know,” many investors subject themselves to unnecessary transaction costs and income taxes and miss out on much of the appreciation in the markets by attempting to be out when prices are falling. The sad reality is that many investors in any given stock or mutual fund earn significantly less over time than what investments actually returns… due to trading in and out of the investment and chasing last year’s winners.
Decisions to invest in a company can be greatly influenced by the way the statistics are framed. If I told you that I once combined with a teammate to score 55 points in a single college basketball game you would assume me to be a much better player than if I “framed” the statistics with the rest of the story, that he scored 49 and I scored just 6!
A company’s presentation of itself is never random. “Our profits surged 150% and our revenue grew by 50% over last year” sounds good until you find out that last year was the worst financial year in company history. “Our stock price reached an all-time high recently at $ 100 per share” sounds awesome until you learn that the price hit $ 99 a decade ago.
The magic of a consistent, repeatable investment process
I am often asked what “secret sauce” we use at Golden Pond Wealth Management that gives us the ability to grow and protect our clients ’wealth over the long term. Well, there is no secret sauce or magic formula. Quite simply, successful long-term investing requires both our clients and us to make a firm commitment to checking our emotions, egos and the “6 Psychological Biases” in this article at the door. Instead, we embrace a repeatable process which is methodical and vanilla plain; customized to the client’s risk tolerance, tax bracket and balance sheet; and one which has stood the test of time over many decades.
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