“You are your own worst enemy” ― Lisa Kleypas, Love in the Afternoon
The human brain is probably the most amazing machine/invention/feat of evolution/gift from god (put whatever superlative you want in there) in the world. Over millions of years it evolved to allow us to outsmart saber-tooth tigers, control fire, figure out how to grow crops, organize millions of individuals, split the atom, splice genes, and on and on. I don’t think anyone can reasonably argue that the evolution of our brain isn’t the single most important factor which has brought us to where we are as a species today.
Yet, as undeniably amazing as our brain is, the instinctual behaviors that were so important in surviving those early years as a species are terrible when it comes to investing. Here is my list of the Top 5 ways that your instincts tend to be wrong when it comes to investing.
5. Keeping up with the Joneses: My dad told me some sage wisdom when I was growing up: “There will always be someone richer or smarter or stronger or faster than you. What you need to do is worry about doing the best you can and forget about them.” That’s pretty great advice in general, but especially in investing.
You’re always going to meet someone who made a killing on Apple or whose portfolio has ballooned to $5 million. First, maybe they’re full of it; investing is like fishing, where everything is exaggerated because that makes the telling of the story more fun. Even if they aren’t exaggerating, who cares?
Investing is a “slow and steady wins the race” type of thing. If you save money and invest it wisely doing all the things we’ve talked about, you’ll almost certainly end up with a nestegg that will meet your retirement needs. But it’s when people start stretching themselves and try to get big wins that things go to hell. Using a baseball analogy, in investing you win by hitting a bunch of singles while never going for the homerun. When you see the Joneses who got lucky when their stock popped, and you get tempted to try to find the next stock that will do that instead of sticking to your index mutual funds, that’s when you get in trouble.
4. Remember the last thing you heard: Psychologically we have something called recency bias, which basically means that we put the most weight on the last thing we heard. This makes sense if you think about it when we were cavemen. If you hear everything okay and then a few minutes later you hear there’s a fire, it’s probably a good thing to believe something is burning.
The problem with investing is that we live in 24/7 news cycle so places like CNBC have to fill hours of airtime. One day they have a story that says Tesla is the greatest auto company ever and their stock will go through the roof. A couple days later they have a story about how sales slowed and the stock is way overvalued. So which is it?
Probably somewhere in the middle. Generally, companies don’t change that much from day to day. If Telsa stock was worth $250 yesterday why would it be worth $220 today? Sure, sometimes there are major news events that can move the needle that much like a court ruling or a natural disaster or something, but those are much rarer than you would think based on the wild swings in sentiment that come out of the financial media. As with #5, this is a case where you need to see past the day-to-day comments and just keep that “slow and steady” approach.
3. Sell too soon: You take the leap and buy a stock or mutual fund. And then it goes down. Holy crap!!! What just happened? I screwed up and need to get out of this before I lose any more. So you sell too soon. Yet just a little bit ago you thought it was a good investment, so why are you selling now?
In the light of day it’s easy to see this is a mistake and your emotions are taking control from your intellect, yet it happens all the time. This is especially true in a media environment where we’re constantly bombarded with reasons to buy and sell. The “slow-and-steady” investor is going to ride out those storms and hold on to the investments that were good ones yesterday, knowing that they’re probably still good ones today.
3a. Hold the stock too long: The cousin to selling stocks too soon, is holding them for too long. I am personally guilty with this with commodities. Over the past couple years they have taken a nosedive, down about 50%. But I refuse to sell because I am “waiting for them to come around”.
There’s a lot of reason to think that commodities are going to continue to fall—more oil discoveries, the world economy and especially China’s is slowing down. Of course, who knows what will really happen. But I think psychologically, I just don’t want to sell because that will be admitting that I made a bad investment choice. Intellectually I know I should probably move on and sell my commodities, but I just can’t do it. Pride is something you can choke on.
2. Try to figure it out: Our brains have a pretty good track record of figuring things out—math, physics, weather, biology. Not bad. So it’s understandable that we have this desire to figure the stock market out, and even more powerful, a belief that we can.
Yet the stock market is a different. It is people that make the stock market go, with all their irrational behavior (like the things we’ve discussed here). Because of that, I believe the stock market is totally unpredictable over the short term. But many people don’t share that opinion, and they spend inordinate amounts of time trying to figure it out.
Some of it can be more simple stuff like “the stock always does better after the earnings report”. Or it can be hard core like all the technical analysis that uses stock charts, 200-day moving averages, open options, float and volume, and a million other factors to try to tease out what will happen in the future.
I am not a believer is that stuff. Rather, I accept that in the short term the stock market is going to act erratically but over the long term it will have a steady upward march. So I invest in index mutual funds with every paycheck and not try to beat the system.
1. Get while the getting is good: Momentum investing is so tempting. If a stock is going up, it’s easy to imagine that it will keep going up. If everything is going to hell like has been happening the past couple days, it’s easy to imagine things will stay bad. Similar to the ones above, this makes sense from an evolutionary perspective. As a caveman, if the land was giving really great harvests, it made sense to stay there and enjoy the bounty. If panthers already ate a couple villagers, maybe it’s time to go somewhere else. There wasn’t really this idea of riding it out or waiting for things to even out.
However, in investing balancing out the ups and down (it’s called “mean reversion”) is a tried and true concept. When a stock is going up a lot, we know that it can’t go up forever, and at some point it will probably come down to more rational levels. Of course we never know when that’s going to be. In the meantime, it’s easy for our “animal spirits” to take over and want to keep riding the stock up and up. This situation isn’t helped by the media which understandably reports on the biggest movers, reinforcing the message that “XYZ has been going up and here’s why it’s so great.”
But this is a sucker’s game. Warren Buffet is famous for saying: “Get scared when everyone is greedy, and get greedy when everyone is scared.” Again (notice how the same advice keeps you out of all these blunders), you can save yourself from this by just investing in broad mutual funds (instead of trying to pick individual stocks) and investing regularly (like with your 401k contributions) rather than trying to time the market.
So there you have it—my list of blunders that our hypothalamus is constantly trying to steer us towards. And they’re tempting. I am certainly guilt with some of these. Yet if you know these blunders are out there, you can take steps to avoid them. And avoiding them, even if it leads to just a 1% better return, can make a huge difference.
As cavemen, we were playing a harsh game where the cost of even a small failure was often fatal. Decisions needed to be quick and they needed to be bold. And you know what, that worked for us. Look how far we have come as a species. But all those things that allowed us to thrive as cavemen poison our investing returns. In investing, you really need the opposite—slow and steady moves over a long period of time.
What do you think? Are there any blunders I missed?