The Psychological Mistakes Investors Make, Part 2

I kicked off this occasional series of articles for Early to Rise in Message #1160 with an excerpt from a chapter of my book “Bull’s Eye Investing” that my old friend Michael Masterson tells me “is worth the price of the entire book.”

In that chapter, I identify 11 psychological mistakes that investors commonly make and provide guidelines for overcoming them. I covered the first one for you in my first article.

Since it’s been a few months since you’ve heard from me, let’s start with a quick review of my first rule before we move on . . .

Guideline No. 1: You know less than you think you do.

People tend to believe that the more information they have, the more capable they are of making good investment decisions. But the simple truth is that more information is not necessarily good information. It is what you do with it, rather than how much you have, that matters. The “illusion of control” and the “illusion of knowledge” leads to over-optimism and overconfidence — a potent combination.

It leads you to overestimate your knowledge, understate the risk, and exaggerate your ability to control the situation. As a result, you make the mistake of making bold forecasts and timid choices. And that brings us to our second rule

. . .

Guideline No. 2: Be less certain in your views; aim for timid forecasts and bold choice. People also tend to cling tenaciously to a view or a forecast. Once a position has been stated, most people find it very hard to move away from that view. When movement does occur, it does so only very slowly. Psychologists call this “conservatism bias.”

Stock analysts, for example, are exceptionally good at telling you what just happened — but not very good at predicting what’s going to happen. (In fact, one study shows that the average analyst is wrong by more than 50%.) They stick to what “was,” and change a forecast
only when presented with indisputable evidence of its falsehood. This means they usually change their views too late to be of any real use to you.

Investors should note that these analysts are professionals. We tend to think of them as accountants sitting around looking at tables, numbers, and mind-numbing mounds of data and coming to a rationally based conclusion. The real view is that they are all too human and their humanity shows up all too readily in their forecasts.

This leads to our third rule . . .

Guideline No. 3: Don’t get hung up on one technique, tool, approach, or view. Flexibility and pragmatism are the order of the day. We are inclined to look for information that agrees with us. This thirst for agreement rather than refutation is known as “confirmatory bias.” The classic example is to consider the following test.

First, look at the four cards below. Each is labeled with a letter on one side, and a number on the other. If I tell you that if a card has a vowel on one side it must also have an even number on the other side, which card(s) do you need to turn over to see if I am telling the truth?

[E] [4] [K] [7]

Before I give the answer, consider the following. You have been employed at a nightclub as a bar manager. However, the club is keen not to allow underage drinking. If someone is under 18 years old, they must not drink alcohol. Now, in the problem below, each card is a customer. The card gives the customer’s age on one side and what he/she is drinking on the other side. Which of these cards do you need to turn over to make sure there is no illegal underage drinking going on in the club?

[drinking beer] [25 yrs old] [drinking coke] [17 yrs old]

In both cases, the correct answer is the first and last cards only. In the latter problem, this should be obvious. You are looking only at those people drinking alcohol, and only at those people under the legal age for drinking. In the former problem, these are the only two cards that can prove I was lying. (If you thought E and 4 — as most people do — you are suffering from confirmation bias, looking for information that agrees with you.)

Only E and 7 are capable of proving that I was lying. If you turn the E over and find an odd number, I lied — and if you turn the 7 over and find a vowel, I lied. By turning the 4 over, you can prove nothing. If it has a vowel, you have found information that agrees with my statement but doesn’t prove it. If you turn the 4 over and find a consonant, you have proved nothing. At the outset, I said that a vowel must have an even number, not that an even number must have a vowel!

How the problem is “framed” affects our answers. By picking 4, people are deliberately looking for information that agrees with them. Our natural tendency is to listen to people who agree with us. It feels good to hear our own opinions reflected back to us. We get those warm fuzzy feelings of content.

This is all tied up in our human quest for certainty. It is notable that we tend to associate with those who think like we do and confirm the rightness and wisdom of our judgment and views, whether on investments, politics, or religion. This only reinforces the tendency to set in concrete wrong views and notions. Sadly, this isn’t the best way to make optimal decisions. Instead of listening to the people who echo our own view, we should observe the fourth rule . . .

Guideline No. 4: Listen to those who don’t agree with us. The bulls should listen to the bears, and vice versa. You should pursue such a strategy not so that you change your mind, but rather so you are aware of the opposite position.

The final bias we look at today is one of self-deception called “hindsight bias.” It is all too easy to look back at the past and think that it was simple, comprehensible, and predictable. This is hindsight bias — a tendency for people knowing the outcome to believe that they would have predicted the outcome ex ante.

The best example I can think of is the U.S. stock market over the past few years. Now, pretty much everyone agrees that the U.S. market witnessed a bubble, but calling it a bubble in 1998, 1999, or 2000 was an awful lot harder than it is now! This faith in our ability to “forecast” the past gives rise to yet more bias toward overconfidence.

This leads to our fifth rule . . .

Guideline No. 5: You didn’t know it all along; you just thought you did. We’ll start there next time.