Investor Psychology: “How beliefs and behavior sabotage success in the investment industry”

The Instinct to Fail

Human beings, no matter how intelligent, tend to make similar mistakes. Because our brains are pattern seeking systems we often see patterns where they don’t exist. This is easier to understand when you realize that natural selection works by throwing away individual failures so that the arc of beneficial adaptation happens over time and population. What this means is that the calculus of your gut instincts is not aimed at your own personal survival, it is aimed at the survival of the species.

It is a difficult lesson to learn, especially in such a massively individualistic society as ours. But it is one that every investor must learn. So, we will discuss a few fallacious modes of thought that can derail even the most talented investors from time to time as well as some ways to avoid them.

Flash Panning

Perhaps the most common, and dangerous, pitfall to investors is the Post Hoc fallacy, or the Texas Sharp Shooters fallacy. This is an error where we see patterns that do not necessarily exist. The form this most often takes for investors is in extrapolating from recent gains in a stock to predict the future of that stock’s performance. It does not follow that because Brand X performed well last quarter, that it will continue to do so in the future. It’s not the worst mistake. But you can avoid it by refusing to invest in any single piece of evidence like past performance.

Under-diversification

Common at it is, under-diversification is an ancient behavioral strategy that has developed as a way to cope with scarce resources. A hunter who had only one special spear might have tended to think very highly of that spear and possibly even attribute supernatural properties to it. This is no way to treat any single item in your portfolio. It is common knowledge that diversification is crucial to the success of any investor. However, the urge to rely too heavily on favored stocks can be strong. This kind of mistake is most often made when an investor has become decision weary. In that case it might be best to take a vacation, and recharge your executive function.

Betting with Your Heart

There are endless temptations to make investment decisions based on the desire to seek comfort rather than selecting stocks in accordance to the best evidence at hand. People tend to bet on their favorite sports organizations rather than the one with the best players.

Another common way to be misled is by choosing stocks based on their popularity. It is very common for investors to select popular assets. This is understandable, worse, it’s forgivable. And that’s what makes it so seductive. It is, after all, rational to be wary of being both wrong, and alone. As the famous economist John Maynard warned, the dangers of failing unconventionally include the condemnation of one’s peers. Succeeding as an outlier is fortuitous. Failing as one is disaster.

How to Avoid These Mistakes

Unfortunately, there is no substitute to taking the time to develop a year-round investment strategy. Know how specific stocks perform during different times of the year. Invest in the evidence. Do your research and avoid the temptation to follow hunches.

Investing in popular assets is not entirely without merit as there is often wisdom in crowds. What’s important is to be sure that you can actually see the advantages of a given stock for yourself and that you are not just following a trend.

Diversify your risks. If you have to take on risks, take on a number of small ones rather than fewer larger ones so that losses won’t be disastrous.

Above all, listen to your heart, but trust your head.

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