As I’ve mentioned approximately 5,395 times on the FU machine (author’s estimate, although I’m 99% sure that’s right), your feelings are mostly getting in the way of financial success. People do silly things like refuse to take interest free (or heavily subsidized) loans from their parents because of things like “pride”, even though taking a loan like that can potentially save them thousands in interest.
The same logic applies to heavily-indebted millennials who refuse to move back into their parents’ basement.
In fact, I’m willing to bet there’s a pretty strong inverse relationship between the amount of money somebody has and the amount they care about this kind of stuff. I constantly see examples of people with no money doing “what’s right” even though it’ll cost them thousands of dollars compared to the easier thing.
It’s like bankruptcy. If you borrowed an assload of money on credit cards and can’t afford to pay it back, maybe bankruptcy should be an option. Yeah, you probably have a moral obligation to pay back the loan(s), but screw that. If you’re comfortable wiping out your debt in exchange for having less access to credit for a number of years, then go ahead and declare bankruptcy. It’s silly to not do something legal to further your financial situation.
There are a million other examples, like people paying the lowest balance loan down first instead of tackling the one with the highest interest rate, but we won’t focus on them. Instead, let’s talk about how the same kinds of mental mistakes trip up even those of us who are past the financial basics.
The market is filled with millions of deeply flawed individuals with one common goal — to make money. It really makes your group of friends look normal, except for that guy with a foot fetish. Give that guy a lobotomy already.
Together, all these FREAKS form a market that’s actually pretty smart, at least most of the time. The only real pockets of value are in the small-cap or micro-cap space. Like I argued in the linked-to post, probably 98-99% of the S&P 500 is efficiently priced. Therefore, I tend to eliminate it when I search for investment opportunities.
Probably the best way for the regular Joe investor to get away from all this is to take his savings each month and plow it into an index fund or three, preferably through a provider like Questrade that doesn’t charge anything to buy ETFs. It’s easy, and you can dedicate the time you’d normally spend researching companies to a more profitable endeavor, like selling your body.
Still, there are certain investor biases you have to watch out for, like these four.
I touched on this a few months ago when I explained why backtesting your portfolio is 14 different kinds of useless.
Here’s the way many dividend growth investors approach stock selection. They find a list of companies with streaks of 5, 10, or even 25 years of consecutively raising dividends, and then use it as a starting point for what to buy.
There’s a big potential problem with that. There’s nothing that proves these companies will continue to outperform in the future. By almost exclusively looking backwards, the average dividend growth investor (or any investor who depends on backtests) is omitting a very important part of analysis. Yes, history does tend to repeat itself, but looking backwards is a poor predictor to the future.
Dividends aren’t such an accurate predictor of outperformance either, at least lately.
Besides, look at a company like Wal-Mart for validation. It did extremely well for years, and has basically been dead money since 2008.
Recency bias is a really simple piece of psychology, but it’s amazing how many people I see fall victim to it. Humans tend to place a greater emphasis on something that just happened.
The best example of this is a roulette wheel. You have an approximate 50/50 chance between hitting red or black. After 3 spins in a row hit red, people will react in one of two ways. They’ll either bet red because it’s “hot” or they’ll bet black because it’s “due.”
In reality, the odds haven’t changed. We just look at the most recent spins more favorably because we remember them. Like the last spin and the one before it, the odds are pretty much 50/50.
Recency bias is why momentum trading strategies actually work, at least sometimes. People like stocks that are going up and hate ones that are going down, even if the fundamentals don’t justify moves like that.
Hindsight bias is pretty similar to survivorship bias.
There’s no indication that a company which has outperformed for years will continue that out-performance. And yet, there are thousands of investors who will base their investment decisions on that.
The best example I can think of is Altria, the largest cigarette maker in the U.S. It’s been a terrific stock over the last 4 decades, and has done especially well after about 1998. But it now trades at about 20x earnings when 14x earnings has been the historical norm, and each year the company’s volumes go down slightly as more people quit smoking than start up.
Everybody focuses on the outperformance over the years, while ignoring the very real risks going forward. That’s hindsight bias at work.
Correlation and causation
This one is my favorite.
I like to explain the difference between these two terms by looking at the gap between high school grads and folks who graduate from college. A wage gap exists between the two, which is commonly attributed to the extra education.
But is the extra education the real cause? Or does it have to do with other factors? Somebody who is smarter and more ambitious is more likely to get some sort of post-secondary education. Do they make more because of the education? Or because they’re smarter and more ambitious?
The answer isn’t as obvious as you think. Everybody thinks they’re correlated, and more schooling must cause an increase in earnings. As a counter, I’d like to point to the thousands and thousands of high school grads (and lower) making good money.
Investors fall victim to this all the time too. Two energy stocks are likely both falling because of the price of oil. But two consumer goods companies might be falling for two completely different reasons.
That’s it, I’m bored
That went a little long. If you can think of anything I missed, the comment section is all yours.