25 Symptoms or Conditions that Give Rise to Investment Mistakes

Investment Rx: Do You Suffer From any of These 25 Symptoms or Conditions that Give Rise to Investment Mistakes?

    1.  Do You Project Recent Trends Indefinitely into the Future?

If you do, you are buying yesterday’s gains or selling yesterday’s losses.

    2.  Do You Believe Events Are More Predictable After the Fact Than Before?

Then you suffer from Hindsight Bias. 

Do you regard past stock market declines as an opportunity, but current declines as risky? 

People suffering from Hindsight Bias tend to exaggerate their own pre-event estimate of the probability of an event occurring.  This causes a belief that investment outcomes are far more predictable than they actually are.

    3.  Do You Extrapolate from Small Samples and Trust Your Intuition?

You will then arrive at faulty conclusions drawn from limited information due to intuition trusting.

    4.  Do You Allow Yourself to Be Influenced by a Herd Mentality?

People think in herds.

Investing has become a social activity and, unfortunately, people become less sensible when they are part of a crowd or group-think.

    5.  Do You Confuse Skill and Luck?

Even a blind squirrel will find a nut.

    6.  Do You Pay Attention to the “Experts”?

“Predictions about the stock market tells you nothing about where stocks are headed, but a whole lot about the person doing the predicting.” …. Warren Buffett

    7.  Do You Let the Price Paid Affect Your Decision to Continue to Hold an Asset?

If so, you suffer from the Endowment Effect. 

This condition causes investors to continue to hold assets they would not purchase if they did not already own them.

    8.  Do You Confuse the Familiar with the Safe?

Something familiar is not necessarily safe. 

Symptoms manifest as a preference for familiar over unfamiliar risks.

When familiarity creates a sense of safety people tend to view domestic stocks as safer than international ones.  This was surely the case with Japanese investors in the 1980s preferring the familiar, highly overvalued and unsafe Japanese stock market to the unfamiliar U.S. or Europe.  To this day, the Japanese stock market has failed to return to its high of the late 1980s.

    9.  Do You Confuse Information with Knowledge?

Something that everyone knows isn’t worth knowing.

    10.  Do You Confuse Great Companies with High Investment Returns?

Symptoms surface as confusion between business and price risk. 

Business risk measures the volatility of a company’ s business model, while price risk assesses potential investment returns based upon your purchase price.

Great companies have low business risk i.e., their products are continuously in demand, i.e. Starbucks.  Because of their low business risk, however, these same companies often have high price risk. 

Low business risk translates into a low discount rate.   Investors use this rate to calculate the stock price today.That is, they divide the future profits by the discount rate.  The lower the discount rate the higher is the company’s stock price.

This results in high prices and valuations for great companies.  In turn, this produces high price risk because paying a high price for a stock will likely lead to low future returns (see 11).

    11.  Do You Understand How the Price Paid Affects Returns?

Buy                                                      10-Year Return              Price Risk          Business Risk

Stock with a P/E = 22                             5%                                High                 Low

Stock with a P/E = 10                             17%                              Low                  High

Based upon data from 1926-99.

    12.  Do You Get Upset When Your Portfolio Underperforms a Popular Index, i.e. S&P 500?

This psychological condition is known as Tracking Error Regret. 

It is the result of diversification across different and unique sources of risk.  Diversification means having to live through uncomfortable periods when some assets do poorly, i.e. most recently international stocks.

However, it has been noted that the “returns an investor can expect to achieve are directly proportional to the amount of discomfort that they are willing to tolerate.”  (see 24).

    13.  Do You Understand That Bear Markets Are a Necessary Evil?

Necessary in the sense that they restore prices to more healthy levels and remove excesses from the financial system.  They also set the stage for the next bull market.  Kind of like having a root canal, not pleasant but necessary for a healthy mouth.

    14.  Do You Treat the Highly Likely as Certain and the Highly Unlikely as Impossible?

This is a dangerous symptom.

Treating the highly unlikely as impossible causes people to overstate their tolerance for risk.

Prior to 2008 a synchronized nationwide decline in housing prices of -40% or more was thought by many risk “experts” on Wall Street as “highly unlikely.”

    15.  Do You Confuse Before-the-Fact Strategy with After-the Fact Outcome?

You cannot judge performance in any field only by results, but rather the costs of the alternative must be considered. 

That is, what if history played out in a different way? 

This hypothetical illustrates:

Even though the Lakers lost as the last shot rimmed the basket, was having LeBron James take the final shot the wrong call?

    16.  Do You Confuse Speculating with Investing?

Speculating: Bitcoin, tech stocks in 2000, houses in 2007, nifty-fifty stocks in the 1960s

Investing: If I am wrong, my loss will be tolerable.

    17.  Do You Try and Time the Market?

The “signals” used by those who think they can time the market are universally known and, therefore, generally worthless.

    18.  Do You Rely on Market Gurus?

Gurus are always happy to share information (not knowledge) for free.

Also, see 9 above.

    19.  Do You Spend Too Much Time Managing Your Portfolio?

Investment success has much more to do with temperament than intellect.

    20.  Do You Consider Investments in Isolation?

Assets with a negative correlation to your core holdings are highly valuable – they make the other assets look good.

Like a playmaker in basketball.  His or her value to the team is beyond their individual assists in that they make other players look good. 

    21.  Do You Have Too Many Eggs in One Basket?

At the end of 2000 62% of Enron 401(k) assets were invested in company stock – didn’t turn out well.

    22.  Do You Believe Diversification is Determined by the Number of Securities Held?

Successful diversification requires one to diversify across asset classes not within the same asset class.  When the stock market declines all stocks go down.

    23.  Do You Focus on Short-Term Results Even Though Your Investment Horizon is Long-Term?

Then you have Myopic Loss Aversion brought about by risk aversion and the pain of losses.

    24.  Do You Understand How Investment Discomfort Leads to Higher Expected Returns?

When an investment has performed poorly it generally means it has gotten cheaper and thus now has higher expected returns (see 11).

Higher expected returns draw investors increasing the expected return, also known as reversion to the mean.

    25.  Do You Keep Repeating the Same Mistakes?

Hopefully not!