6.3: Investor Psychology and Common Investor Weaknesses
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Because of the tremendous amount of money involved in the markets, much research has gone into trying to understand investor psychology. Some of the research is very revealing about who and what we are, not only as investors but also as a species in general.
“There are three factors that influence the markets: Fear, Greed, and Greed.” – Old Wall Street Saying
In 1962, there was a brief recession and a sharp market downturn. The President’s chief economic adviser was giving a presentation to many of the political and economic leaders of the time, describing what they were doing to right the economy. One of the attendees asked, “So when is the stock market going to recover?” The adviser curtly responded, “I am an economist, Sir, not a psychiatrist.”
What follows is a list of the common investor weaknesses.
Reading Too Much into the Recent Past
Even though there are countless examples of investors “getting on the bandwagon” just as the wagon was about to veer into a ravine, we trick ourselves into believing that, “It’s different this time,” or, “It’s a New Era.” Remember that markets move in cycles. Andrew Tobias succinctly and playfully warned, “Beware the permanent trend.” (That’s an oxymoron. There is no such thing as a permanent trend.)
The problem here is that we are hard-wired to follow the herd. We are social animals. Twenty thousand years ago, when you saw a group of your fellow humans running in a certain direction, you ran that way. The ones who didn’t were eaten by the tiger and did not get to pass on their genes. Fast forward to the modern world and this behavior can kill you, financially, that is.
Examples of this are eToys, TheGlobe.com, or CMGI in 1999. Do any of you remember these stocks? How about condo conversions in 2006 or oil in mid-2008 or gold in 2012? Will we add cryptocurrencies, SPACs, and NFTs to this list 5 or 10 years from now? I think so.
Misperceiving Randomness
Even though stock price movements in the short term are random, our brains will trick us into seeing a pattern. We humans are “heuristic.” That means we look for patterns, even if we know that there aren’t any to be found. For example, in a series of a million random digits, the probability that one digit will be repeated 13 times in a row is essentially 100%. Of course, if you happened across that digit repeated 13 times, you would swear that the series was not random. However, if it did not occur, we would know that the series is not statistically random. Technical Analysts are guilty of this, in our humble opinion. Even when they are told that the data is completely random, they will attempt to interpret the resulting graphs using their Technical Indicators. Again, we will discuss Technical Analysis in our next chapter.
Being Overconfident
We tend to believe we know more than we actually know. Or we believe that we are better than most other investors. The truth is we only see the “tip of the iceberg” with regard to what is happening within a company, an industry, and the economy. And we are usually only average or mediocre investors at best, especially if we decide to become speculators/traders!
This is called the Lake Wobegon Effect, named after the fictional town created by the author and famed storyteller Garrison Keillor. It is our natural human tendency to overestimate our capabilities. If you ask 100 people if they are excellent, good, average, fair, or poor drivers, typically over 80% will say they are excellent or good. This can’t be the case because only 50% are better than average. The effect was named after Lake Wobegon because Garrison Keillor always ends his stories about the town with the phrase, “That’s the news from Lake Wobegon, where all the women are strong, the men are good looking, and all the children are above average.”
Just in case you forgot, remember that when you decide to become a speculator/trader, you are up against the best in the business. Go back to our first chapter and listen to the story of John Meriwether and John Gutfruend from the excellent book, Liar’s Poker, by Michael Lewis. Read it! (Actually, read anything and everything by Michael Lewis. Trust me. You’ll love ‘em all! John Williams of the New York Times Book Review wrote, “I would read an 800-page history of the stapler if he wrote it.”)
Selling Your Winners and Holding onto Your Losers, also known as Loss Aversion
Loss aversion refers to the tendency of people to feel much more pain from experiencing a loss as opposed to experiencing a gain. For this reason, we will often refuse to acknowledge the loss. This is very easy to do with regard to our stock investments. As humans, we hate to admit we made a mistake, so we stubbornly hold onto our losers, hoping that they will at least get back to where we bought them. Then we can sell and tell ourselves we did not lose. The reality is that our memories are hardwired to forget unpleasant experiences. If we sell our losers, we will quickly forget about them. If we hang onto them, each time we review our portfolio, we will always be reminded of our mistakes.
In contrast, we investors tend to sell our winners too quickly. We want to lock in that profit so we can say that we made a good trade and did not lose. However, in contrast, hanging on to the winners is what will make an investor rich. So hang onto your winners! (Psst. Keep doing the research and reevaluate your choices regularly. Has the story changed? Or maybe you have found a better investment alternative? If so, it might be time to sell that winner. You can always come back to it later, especially if it experiences a downturn.)
A wonderful example of why you should hold on to your winners comes from Peter Lynch. Mr. Lynch was once asked what his worst investment decision was. He responded, “Well, I bought Home Depot when it was just getting going. My position went up 100% and I sold.” The interviewers were dumbstruck. They asked how that could have been your worst investment decision. In his wry, self-deprecating style, Mr. Lynch deadpanned, “Home Depot’s stock then went up 20-fold.” Hold on to your winners, Dear Investment Gurus!