A few weeks ago I was browsing through videos on various psychological traps that cause thinking errors. Some were commonly known fallacies, while a few were new interesting ones. As I always state to whomsoever I chat with about investing, it is probably 90% dealing with your mind, and 10% actual knowledge. (I leave aside the luck factor that would cut across everything in some proportion).
Information is aplenty in the current world. As the legendary American Investor Peter Lynch of Magellan Fund states in his conversations, everyone has access to the company performance data at a similar level (leaving aside insider information). There were times when you used to request a company quarterly report which used to take weeks to ship a physical copy. The problem now is, overindulging in this information and reacting more to it than ideally should. Here are a collection of some of the psychological games our mind plays.
Sunk Cost Fallacy
— I’ve invested so much into it. It can’t possibly back off now.
Have you ever invested time, energy, money, or any other kind of resource on something, or maybe someone, and seen it going nowhere, or worse, deteriorating? You then feel the urge to stay on that path and invest further. Your mind is thinking, I’ve come so far, and I just can’t let it go now. This is what many experiences when an invested stock price is tanking. We fail to understand the concept of “Stop Loss” and stick to the dead weights. Instead, knowing the very set of reasons which led to the original investment decision, and re-verifying whether they still hold good in the current day would be a more rational step.
Confirmation Bias
— I am always right. I just need to seek affirmation
Have you ever invested or exited from a stock, and continued to track the stock news? But for what purpose is the question? Is it to look for fresh data points for future opportunities, or to seek validation on the decision you have already made? If it’s the latter, then you are caught up with confirmation bias. With free information at heavy disposal, you could always find something that reinforces your decision. It doesn’t mean that’s the best information. Confirmation bias leads us to have a closed mind from accepting alternate and new views.
I remember keeping a watchlist of all the exited stocks, not for any interest other than self-validation of my sell decision! In the process, I have lost out on many new entry opportunities.
Gambler’s Fallacy
— This sequence of events doesn’t make sense
In a basket of stocks within a specific business sector, you feel the urge to rotate your portfolio by switching between stocks. If a stock has given a runway profit over a while, we are tempted to feel it won’t stay consistent and now is the chance for the duds to rise. We make the mistake of switching the investment. Imagine a flip of a coin, where there is an equal probability of head or tail occurrence. But a gambler seeing 3 consecutive heads might be tempted to bet on a tail speculating it’s highly unlikely to have a head this time! And this is a big fallacy.
Making a decision based on the stock valuation in isolation is fine, but playing a law of averages game where you expect all stocks to be equally valued may not be the right deciding factor for a switch.
The Paradox of Choice
— I need more choices to make the best decision
In the pretext of diversification, we hold onto a bucketful of stocks with no clear plan. And with more stocks to manage, comes the dangers of decision fatigue and not being able to compare and contrast the right parameters. Psychological experiments have shown that will fewer choices to pick from, there is lesser regret of missing out on the “better” choices. Imagine analyzing the entire bucket (or even the top 50) of Large cap stocks from a listed index (which are supposed to be promising and less volatile) and deciding among them.
Clustering Illusion
— THIS LOOKS FAMILIAR TO ME
Try looking at the stars on a clear night. Focus for some time and you will be able to form a pattern in your sight. Reset your view, and repeat at the same spot, and you could come up with something different this time. Our mind is equipped to create illusions out of what we see.
Investors are constantly bombarded with technical charts and patterns to help make future decisions. Technical charts are trailing indicators. The data can be crunched to fit into different patterns. It is similar to the correlations done in the world of ML/Data Science. Understanding patterns and making controlled investments is one thing; hinging on the patterns to make super aggressive and risky investments is best to avoid.
Self Serving Bias
— If something goes wrong, I’m not to be blamed
And for everything that goes right, it has to do with my talent and skills! It’s a common behavior bias that has implications in investing to the effect that you stop growing up as a better investor compared to yesterday. A lot of gains that happen in stocks could be attributed to pure luck, but we are tempted to think it was a calculated decision (while in reality there were none!). On the flip side, an incorrect decision could be attributed to pure bad luck.
It’s not easy to get out of all these biases. After all we humans are fallible. The most dangerous bias is “I don’t have any bias”! So a good start to negating these is acceptance, and correlating them gradually to your investment actions.
