When it comes to investing, do you follow the herd or follow sound principles? Ask yourself if you look around to see what others are doing or if you’re influenced by media hype and attention.
Remember just two summers ago when stimulus money flowed freely, and the markets were riding a massive wave of hype and hysteria? The stock and crypto markets were at all-time highs. Newbie investors and investors flush with cash were jumping on one hype train after another.
Remember meme stocks? Meme stocks were stocks fueled by social media and internet hype with no underlying principles of rhyme or reason for their rise. Two summers ago, meme stocks were often stocks of companies that had already filed for bankruptcy or were on their way there. It didn’t matter because everyone was making money.
2021 was a crazy time. Everybody was on the hype train, from 80-year-old veterans talking about hitting it big with Bitcoin to Uber drivers retiring off gains from Gamestop (GME) shares.
Celebrities also got in on the act – peddling crypto and crypto exchanges like they were the next big thing. Then there were NFTs.
Remember NFTs? A non-fungible token is essentially a unit of data on blockchain representing a unique digital item, such as digital art, audio, and video files. Creators were making bank selling ridiculous but unique art pieces that investors were snapping up because everyone wanted a piece of the action.
2021 was great for some investors, but as with most bubbles, it all came to a screeching halt. The stock and crypto craze didn’t last. Most investors lost their shirts in 2022 when it all came crashing back to Earth when stocks and crypto fell back to pre-2021 levels.
Although many investors lost a lot of money from meme stocks, crypto, and NFTs in 2021 and 2022, that won’t stop investors in the future from jumping on the next hyped-up trend that comes along. That’s because investors are susceptible to “outcome bias” that clouds sound investment decision-making.
Outcome bias arises when a decision is based on the outcome of previous events, without regard to how the past events developed or to whom they happened.
Novice investors may conclude that the quality of the outcome (i.e., high returns) confirms that they have a knack for picking winning investments. Or seasoned investors may see other investors succeeding and assume they’ll see the same results.
The problem with outcome bias is investors sometimes get lucky. In the early stages of the 2021 hype train, people looked around and saw their neighbors, colleagues, family, and friends having success with stocks and crypto. Investors who come in later to the game assume they’ll have the same success as those who got an earlier start. This is how outcome bias fuels bubbles.
Over the short term, an individual investor and investors, in general, can experience a win in the markets simply by getting lucky. This doesn’t mean they will get lucky every time, as is often the case.
The problem with outcome bias is that investors will assume the worst once things start to go south. Experiencing loss or seeing others experience loss is a signal for most investors to head for the exits. Outcome bias is just another example of herd behavior. On the flip side, some investors don’t make investment decisions based on outcomes – whether their own or the outcomes of others – but instead, base their investment decisions on sound principles.
Savvy investors exercise discipline in their investment choices by investing based on sound principles. They don’t jump on every trend or abandon ship at the first sign of trouble. An asset in which they’re invested may suffer the occasional speed bump. Still, they remain steadfast because they know that based on history and sound economic principles, their asset will persist and perform in the long haul.
What are some questions to ask to determine whether you’re investing based on hype or whether you’re investing based on sound principles?
ONE: Do you understand the investment?
One of the biggest mistakes people make when investing is investing in things they don’t understand. They’ll invest in NFTs, crypto, and meme stock not because they understand them but because their friends and colleagues are investing in them. Unless you take the time to understand what you’re investing in and how you can expect to make money, you’re investing based on bias, not on sound principles.
TWO: Are you willing to part with your money for a long time?
Liquidity enables rash decision-making. It undermines principled investing. If the market hits a speed bump, many investors allocated to liquid assets will jump ship at the first sign of trouble. Smart investors allocate to assets that lock them in long-term to self-impose discipline, allow the asset to mature, and let returns play out in the long run instead of jumping ship too soon and missing out.
THREE: Is there transparency between you and those handling your money?
Do you know who’s handling your investments and how your money is being handled and invested? Is there transparency between you and the stewards of your money? Transparency is why smart investors gravitate towards private investments, where the managers and sponsors of a private investment fund make themselves available to answer questions about their background and expertise and how they intend to maximize the probability of success of the investment.
Asking three simple questions can be the difference between rushing headfirst into the next trendy investment and losing money or sticking to sound investment principles to generate steady, consistent returns over the long haul.