How your implicit bias undermines investing
Mitchell Barr, Client Associate
Through a lifetime of investing, the chances are you are going to make your fair share of mistakes. It happens to even the most successful investors in the world. Ray Dalio, the founder of Bridgewater — currently the largest hedge fund in the world — once predicted an economic depression in the early 80s. He was so confident he was right he testified before Congress to warn of the imminent collapse. The US economy went on to experience an almost decade-long expansion until the next recession that began in 1989. Bridgewater almost completely disappeared after Mr. Dalio had to let every employee go besides himself. His mistake, in this case, was hubris, and he now credits that failure for helping him gain a sense of humility and building Bridgewater into what is today.
The lesson we can learn from Ray Dalio is that hubris, along with myriad other behavioral foibles, are often to blame when we make stupid investment decisions. The most effective way to stay ahead of these havoc-wreaking monkeys in our head is to know what the issues are. We can’t always avoid losing money when investing, but we can improve our decision-making by asking ourselves a few simple questions.
Have you thought about the investment for over 24 hours?
There’s a long line of stupid investments that can be attributable to pride, fear, and excitement. Emotions have no place in making good investments.
Let me repeat that.
Emotions have no place in making good investments.
A sound investment should be made through logical reasoning and critical thinking. Simply applying a waiting period to your decision-making process can go a long way in reducing an initial emotional response that might trick you into a get rich quick scheme or lottery ticket-like investment. The stock market can resemble a casino if you treat your livelihood like a trip to Las Vegas. Don’t gamble away your life savings because you got caught up in the “thrill” of investing.
Have you thought about how the investment could fail (or succeed)?
All investments carry risk. Despite that, humans tend to be supremely overconfident in their investment decisions. If you haven’t contemplated the fact that an investment might not turn out the way you want it to, you need to stop right there. This type of one-sided thinking is partially what got Ray Dalio in trouble.
Asking yourself how an investment could fail will help you avoid the investments that sound too good to be true, because they are. It will also force you to decide how much money the investment warrants investing in. If it disappears and you lose your whole investment, will you be okay? Asking yourself the question will lead you to naturally diversify your portfolio and avoid concentration in one investment, which can be psychologically draining and cause undue stress.
On the flip side, the whole point of investing is to make money. We are quick to believe that an investment might make money, but whether or not it will make money is always an unknown. Ask yourself, how will this investment create value? as a reality check on the probability of its success. Depending on validity of the investment’s method of making money, you can decide how much money it warrants investing. Do your research using fundamental analysis and dig into the weeds if you like numbers, or use deductive reasoning to double check that you have a chance of getting paid back. If it were easy we would all be millionaires, but you should at least have an idea of what the value proposition is of your investment.
Have you sought out an alternative viewpoint on the investment?
If your investment research consists of reading articles and listening to commentary by people with your same viewpoint, of course, the investment is going to sound like a good idea. Humans are biased to only absorb information that is in agreement with our view of the world. You have to be open-minded as an investor and seek out the opinions of people who don’t agree with you.
Once you listen to what others have to say, you can then determine whether they are right or wrong. Acknowledge new information appropriately when you receive it, because “under correction” to new information is a rationalization technique that your brain will use to convince itself it’s correct. In the book Superforecasting by Phillip Tetlock, he found that the most successful forecasters in the world update their forecasts often and in small increments to avoid over/under reacting to new information.
Are you making this investment based on recent news?
Our brain uses shortcuts to make decisions from the information that is most readily available. The result is that recent events play a larger role than past events in your decision making. You might not even be conscious that you are doing this. A couple of years ago I asked my wife to marry me. Before the proposal, I went to the jewelry store to pick out her engagement ring. I walked around the store with the salesperson for a few hours, but there was this one setting that seemed to be the perfect fit. I bought the setting and my wife said yes (woohoo!).
A week later I was sitting at a stoplight and looked up at a billboard for the jewelry store where I purchased the ring. I had been driving past a massive image of my wife’s engagement ring for weeks before I bought it. That’s subliminal marketing at its finest.
If you hear the news media say “retail is dying” over and over, your brain will start to draw on that message when you are making an investment. This theme has been so prevalent that financial products such as Proshares Decline of the Retail Store ETF (EMTY) exist solely to profit from trendy investment ideas that may or may not have any merit. Proshares doesn’t care if the investment thesis is correct, they are simply marketing a product to take advantage of human bias. Think about the larger picture before making an investment decision and you might find that you are working off of questionable assumptions you picked up subconsciously in the news.
Are other people investing because this is “The Next Big Thing?”
Take your pick of investments in today’s world that are going to be The Next Big Thing. Tesla, Bitcoin, and Amazon seem to rule the world. The problem with investing in the next big thing is that everyone knows it’s the next big thing, and they buy it. The price gets bid up, which raises the hurdle to achieve future gains. It can also increase volatility as people herd in and out like cattle when the price moves. Do you have the intestinal fortitude to watch your investment bounce up, down, and all around while people decide if they are in or out?
The truth is, we have no idea how to figure out what the next big thing will be. Computing power has been doubling every 12 to 18 months, and technology is changing so fast, that what exists now will be obsolete in the future. Trying to keep up is a fool’s errand. Research Affiliates, an investment research company dedicated to creating value for investors, recently wrote about this phenomenon.
“At the beginning of 2000, the 10 largest market-cap tech stocks in the United States, collectively representing a 25% share of the S&P 500 Index—Microsoft, Cisco, Intel, IBM, AOL, Oracle, Dell, Sun, Qualcomm, and HP—did not live up to the excessively optimistic expectations. Over the next 18 years, not a single one beat the market: five produced positive returns, averaging 3.2% a year compounded, far lower than the market return, and two failed outright. Of the five that produced negative returns, the average outcome was a loss of 7.2% a year, or 12.6% a year less than the S&P 500.”1
Picking and choosing which companies will be around in the next twenty years is a daunting task, let alone identifying the companies that will be the best performers. Proceed with caution if you are tempted by a company that is being heralded as The Next Big Thing, because AOL can turn into LOL in the blink of an eye.
Have you decided how long you will hold this investment?
If you plan on exiting the investment sometime in the future, figure out when and why you want to sell. To eliminate the stress of deciding when to sell altogether, limit your investments to things you plan to hold forever. If the investment drops in value by 30 percent and you have no management plan, you are going to experience one of two things. Either you will give in to your emotions and sell at a low point, or you will get analysis paralysis and do nothing, only to give in to your emotions at a later date and sell at an even lower point. An exit plan is of supreme importance for making good investment decisions and having peace of mind when the times get tough.
Invest, or don’t
If you can make it through the Stupid Investment Decision Avoidance Method by successfully addressing each of the above questions, you’ve carefully thought the investment through before going forward. In addition to validating your investment thesis, you will avoid the regret of knowing you made a bad investment decision because you succumbed to the cognitive deficiencies of your brain.
Even if you make it through all the questions, you might decide you don’t want to make the investment, which is okay too. Many people feel like they should always be doing something with their portfolio to stay ahead when in reality being a boring investor can be successful and offer greater contentment than going through the emotional rigmarole that comes along with any investment decision. You won’t be right 100 percent of the time (no one is), but you can reduce stupid investing mistakes by asking yourself a few simple questions.
- Arnott, R., Shepherd, S., & Cornell, B. (2018, April). Yes. It’s a Bubble. So What? Retrieved from https://www.researchaffiliates.com/en_us/publications/articles/668-yes-its-a-bubble-so-what.html
Mitch writes the popular blog, The Money Monkey, where he focuses on common mental mistakes made by investors, how to avoid being your own worst financial enemy, and thinking about investing in new ways.