5 Ways Your Brain Tricks You Into Bad Investment Decisions

You are rational with your money. You spend weeks agonizing over the new microwave oven. You read countless reviews and compare features and prices. You worry about risk and insist on a good warranty. You demand value for every hard earned dollar you spend.

I expand on risk and investor behavior in this presentation for AAII – Eastern Michigan Chapter (powerpoint)

When it comes to buying stocks, however, the story is different. There is something about money and investing that causes temporary lapses in logic and reason. It leads you to sell at the bottom and buy at the top. It warps your perception of risk. You probably think Apple stock at $450/share today is more risky than you thought it was just 5 months ago at $700/share. You are not alone.

[Click to enlarge]

5 ways your brain tricks you into bad investment decisions - infographic
Click below to embed the infographic in your site

“Stock prices have reached what looks like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break from present levels, such as (bears) have predicted. I expect to see the stock market a good deal higher within a few months.”
- Irving Fisher, Professor of Economics at Yale University, Oct. 17, 1929, days before the market crash

When it comes to investing, the so called “experts” operate with the same handicap as the rest of us.

Successful investing is about how you improve your odds

Your investing process needs to continually evolve on two fronts:

  1. You need to select investments in a way that removes possibility of losing money as much as possible. You can do this by refusing to overpay for an investment, trading as little as possible, and learning everything about the company that you can before committing your dollars to its stock, and,
  2. You need to work on your own behavior and emotional response and find ways to remove it from interfering with your investment decisions

Once you learn how to manage and reduce your downside, your average returns are automatically improved. Ultimately, investing in stocks is betting that the future will turn out to be better than it looks today and the future always has a degree of unpredictability in it regardless of how solid your investment analysis is. Just in case things don’t go according to the plan, you will now know the right way to react.

Make a decision and stick to it

Once you make a decision to buy (or sell) a stock, go ahead and buy (or sell) it right away and then stick to your decision unless there is a material change in the business. Time to agonize is before the decision is reached. Any hesitancy afterwards just sub optimizes your performance.

When I buy a stock, I also set a sell price for the stock. Unless there are overwhelming reasons to do so (and these would be very rare), the stock is sold when the price reaches the pre-set sell price, regardless of how popular the stock may have become. In the worst case scenario, I may leave a few points on the table. By doing this it stops me from getting carried away at critical times and forces the right decision at the right time.

This of course is the key to break the loss aversion behavior. If you have parameters set up in your process that calls for a specific action when a certain condition occurs, TAKE THAT ACTION. If it turns out to be the wrong one, you can come back and modify your parameters. If you need additional motivation, try reframing the question that you ask. You will make mistakes early on, but you will avoid them later in your investment career when they are likely to be more costly.

Get the right time perspective

Investors tend to be short term oriented because the long term seems so far off. With this perspective, they are likely to miss things like debt maturing in next 2 years or a costly drawn out legal case against the company or the results of the new strategic initiative bearing fruit. However these may be the things that are driving some of the business actions and the stock price today.

Despite what is commonly believed, most public companies are managed for the long term. To invest properly, your expectations should be in line with the business. Besides, long term is seldom as long as we fear and it comes soon enough.

Remember, when it comes to investing, you may be your own biggest enemy!

Comments

  1. says

    Great article! Thanks for shared this information. Investing too much in a single asset class, industry, or geographic market because you know a lot about it and are comfortable with such decisions.

  2. Uber says

    As a value investor, I find the 3rd “way your brain tricks you” to be interesting. It might seem that value investors have this mental flaw because they often add to their position when a stock price falls, but appearances can be deceiving. If the investment thesis has not fundamentally changed (and that is a big “if”), then a falling stock price is exactly the time when one should add to the position (of course without violating any diversification constraints that have been set up for the portfolio).

    • says

      As long as your decision to buy more is based on the fundamentals without regard to the fact that you own this stock at a higher price.

      If you think that you are losing money and you are driven to buy more because that way you will reduce your average costs, then you are likely to make a mistake since you are not making your decision based on the right things. A lot of times price declines are rational.

      When the internet bubble was bursting, some of the stocks had 80%-90% declines and a lot of good money was thrown after bad.

      BTW, this also works in the reverse. The fact that you paid a lower price before should not stop you from buying the stock at a higher price later if the valuations are better at the higher price.

  3. says

    The examples of “cheap vs. good value” illustrate the point perfectly, but the very choices employed in the example still make me want to buy Kodak. The numbers simply don’t lie. I’d love to get my hands on some Berkshire Hathaway shares, but WTF is the only thing I can say about that share price. Here’s the reality most middle class citizens (sorry to generalize) find themselves in. How can we possibly even begin to participate in the purchase of such shares whose base prices are more than some of our entire families make in a whole year combined? Get real. Even people tho understand the distinction between cheap vs. good would still take their chances on K0dak shares because it’s all they can afford. Nowhere in the above paradigm is the real economic situation of most investors taken into consideration. People go short term and cheap because they’re living from check to check, not necessarily because their brains don’t work or some default in their impulse-control compels them to make bad stock choices. Rather, they have no stock choices of any worth at their income level. Of course, this is all anecdotal.

    • says

      Jackson,

      Two things come to mind:

      1. There is no compulsion to buy Berkshire Hathaway. While it is part of the example, there are countless other stocks that fit the bill. If you do indeed want to buy Berkshire Hathaway, you could always go for B shares that can be purchased for $103/share as of this comment.

      2. While I understand the point about affordability, most times it is better to keep cash as cash if the only other alternative is to buy “cheap” stocks that offer no value. If you spend $1000 to buy Kodak and the stock becomes worthless in a few months of time, it does not matter what price you paid. You still lose your entire investment.

      Cheap for the sake of cheap can be very expensive.

  4. says

    That’s an excellent infographic, I have to admit I’ve never seen it before. I couldn’t agree more that most of us are not wired to make smart investment decisions, though it’s interesting to see people trying out all kinds of things.
    And yes, confusing cheap and good value is so common and applies to many other things!
    Thank you for posting this, I really enjoyed this infographic.

  5. Andrew says

    As I was (almost) drifting off to sleep right now, I thought of two interesting counterexamples from great investors:

    – Seth Klarman said, “Avoiding losses is the most important prerequisite to investment success.” Warren Buffet said, “Rule number one is ‘never lose money’.” Those are both endorsements of loss aversion.

    – John Templeton said, “The time to sell an asset is when you have found a much better bargain to replace it.” Saying “much better” instead of just “anything better” is an endorsement of sunk cost behaviour. (I seem to recall him saying “50% better”, which is a very strong endorsement of sunk cost behaviour, but I can’t find that quote just now.) Completely avoiding sunk cost behaviour would mean switching investments any time the difference in opportunity offered by another investment is greater than the transaction cost of switching, even if the other opportunity only gives you a 1% additional gain. Completely avoiding sunk cost behaviour would lead to a lot of trading.

    Trying to avoid the sunk cost fallacy becomes even worse when an investor is more focused on price than on company fundamentals; if they sell every time a good company’s stock starts falling, they’ll end up in a very bad position.

    • says

      Hi Andrew,

      Loss Aversion is kind of a tricky issue. What Klarman and Buffett are likely referring to is that losses are mathematically (and emotionally) more detrimental to the portfolio returns than the gains are beneficial. This is sometimes casually described as “a 50% loss requires a 100% gain to break even” in popular financial literature. The problem becomes when there are losses already on the books, how would you react.

      One way to avoid making decisions in these scenarios (when rationality becomes suspect), is to avoid getting into these situations in the first place. This is the reason why value investors do their due diligence with potential losses in mind even before investing a dollar in any stock. Margin of Safety, moat, management efficacy, etc are all constructs that are used to minimize the chances of losing money.

      So yes, loss aversion is endorsed by these investors as a general rule but this is more for ensuring that proper due diligence is done before an investment is made. I would extend this by saying that be aware of the potential losses but move if the reward/risk equation is strongly in your favor. Some losses can’t be avoided but in aggregate the portfolio is better off. Generally if you have already thought about potential situations where you could lose money, you are more likely to react rationally if these situations do come to pass. But if you can’t trust yourself to be rational at these critical decision points, try to avoid getting into these situations in the first place.

      Regarding the Sunk Cost comment, I would point out the following:
      1. Saying “much better” instead of “anything better” is NOT an endorsement of sunk cost behaviour for the reason below
      2. For most people, there is a great deal of margin of error when they deem a potential investment as “better”. Instead, when we focus on “much better”, our estimates are in a higher confidence interval statistically and are therefore more reliable. Reduced trading is an added advantage

      We should always strive to look for ideas where odds are strongly in our favor. However, humans are poor judges of odds, and therefore it is important to build in additional safety by requiring greater confidence than merely “better”.

      • Andrew says

        That’s a good point about uncertainty and confidence intervals in deciding whether an alternative investment is actually better.

        I’ve looked a little more at how the researchers talk about loss aversion, and I now see how it’s a problem: It’s not about actual losses, necessarily, but how we can see the same situation as either a loss or a gain depending on how it’s presented to us, and how we have a much stronger emotional reaction in the first case than in the second. I was thinking that “loss aversion” just meant not taking bets with an expected value at or below zero, i.e. don’t buy lottery tickets (expected value below zero) but do invest with a margin of safety (expected value above zero). I was way off in my interpretation of loss aversion.

Leave a Reply

Your email address will not be published. Required fields are marked *