Investing’s Missing Ingredient

TruePoint Capital

Investing’s missing ingredient is the lost art of thinking.

Far too often, investors are driven by everything other than their own rational thought processes regarding investment decisions. A whole field of psychology – behavioral finance – is dedicated to studying investors’ built-in psychological biases that lead them to make irrational investment decisions – often under the influence of external sources.

Behavioral finance explores the roles of human emotion and behavior in financial decision-making and how people’s unconscious biases and inherent aversions influence their decisions in every aspect of the investment process – often to their detriment.

What types of biases prevent investors from making rational decisions?

Here are a few:

Availability Bias.

The availability bias is our tendency to put more weight on information that is more accessible and on our faces. Whatever is getting our attention will be getting the love when we make our investment decisions. The availability bias says investors will invest in what they hear about and see the most since it is whatever’s fresh in their heads. And what’s new in their heads is whatever is being talked about at home, around the water cooler, on social media, and cable news.

In the world of investing, based on the amount of buzz generated on social media, online forums, and the financial press, availability bias favors stocks or crypto, two assets that get all the press. It doesn’t help that free trading platforms like Robinhood make it easier than ever for anyone with a smartphone to invest in stocks and crypto within minutes.

Risk Aversion.

Risk aversion says that the risk of loss far outweighs any potential gain. In other words, fear keeps us from taking risks and trying different things because the pain of loss outweighs any payoff from a win. The evidence suggests that we feel losses at least two to three times as long as we feel an equivalent gain.

For example, you call heads or tails for the chance to win $10. The thought of losing $10 is 2-3 times more painful than the joy derived from the prospect of winning. In the player’s mind, losing is like losing $30 instead of $10, which far outweighs the chance of winning $10. Instead of a $10 gain vs. a $10 loss, it’s $10 vs. $30. The problem with risk aversion is that investors are unwilling to try new things.

Endowment Effect.

We place more value in something we already have than the prospect of making more somewhere else. If we have money in stocks, 401(k) ‘s, or IRAs, the fact that we already have them makes them more valuable than a new and unknown investment that offers the opportunity to earn returns that are 3, 4, 10 times more than what those traditional options provide. This bias means we often hold on to investments to the detriment of earning better returns from alternative investments.

Herding Bias.

This is a compulsion to follow the crowd. There is comfort in the crowds. That many people can’t possibly be all wrong. This herding behavior explains the natural discomfort many investors feel when they break away from the crowd and go out on a limb to invest in something different, something the herd is not interested in. The fear of missing out (FOMO) is a close cousin to the herding bias. If you see a crowd gathering, it’s hard to resist investigating what’s causing all the commotion. Nobody wants to be left on the outside looking in.

Confirmation Bias.

Confirmation bias is reaching for straws. If we have a preconceived notion about something, we’ll view everything as evidence to support that view.

For example, an investor with a negative view of alternative investments and preconceived notions about the high risk of these investments will only concentrate on the negative when they come across or read about alternative investments. They will be biased when viewing the evidence to confirm their preconceived notion of the risk or undesirability of alternative investments.

Stop. Think. Invest.

Author Michael Bailey offers solutions to overcoming our behavioral biases that lead to bad investment decisions. The main ingredient is to think – to use your judgment and analysis before making an investment decision in his book, Stop. Think. Invest., author Michael Bailey explores irrational biases that lead to bad investment decisions, how emotions and life experiences play into all of it, and how to overcome these biases.

His solution is simple:

The first step in overcoming biases that influence our investment decision-making is to Stop. Recognize the biases and the influences blurring your judgment. Recognizing these biases is the first step to overcoming them. If you often make investment decisions based on what your friends are doing and it just isn’t panning out, then recognize that herding is not doing you any favors.

So once you recognize the biases influencing your investment behavior, how do you overcome them? Think

In his book Nudge, author and Nobel Prize-winning economist Richard Thaler suggests overcoming biases by combining both an open mind and taking control. Have an open mind to alternatives to your investment options. Once you’ve done the proper analysis and due diligence, it’s time to take ownership. Choose a path and commit to it.

We have built-in emotional mechanisms and biases that often lead to poor investment choices. To overcome these instincts and biases in our investment lives, Stop. Think. Invest

Stop recognizing how your investment choices are influenced and whether these influences have served you. If not, Think about investment alternatives outside of Wall Street and your circle of influence. Then, once you’ve explored other options and narrowed your choices down to one or two, the next step is to Invest. Take ownership. Choose a path and commit to it.

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