If we rely on our own instincts, they can lead us to make some really silly decisions. Human biases can torpedo your investment performance — so, they’re best avoided or minimized.
That’s the goal of a whole area of research called behavioral finance. Through an enormous amount of experimentation, psychologists and economics have attempted to answer the age-old questions:
Why do we hold onto losing stocks when our rationale for buying the stocks is gone?
Why do we sell winning stocks way too quickly?
Why do we resist making smart financial moves when we can easily see how beneficial they will be?
Why do we act so crazy with money?
Below are some of the most useful findings. Consider this a “cheat sheet” for avoiding these common investing mistakes:
Anchoring or Confirmation Bias: We like to have our opinions confirmed by others, especially so-called experts. Because of this, we will search and find information, data and analysis that will confirm our opinion.
If you want to see this bias in action magnified, talk to someone who is bearish on stock prices. They will cite chapter and verse of all the doom and gloom columnists who share their opinion and drag out charts, graphs and slide shows that clearly demonstrate how and why the world is going to end. They have their opinion, and it’s confirmed by others. Any evidence to the contrary will be ignored. That’s why I try to keep things objective — and go in with the same set of Moneyball criteria that’s responsible for all the best wins of my career.
Gambler’s Fallacy: There is a tendency among people to think that when a coin has been tossed five times and it lands on heads five times it is much more likely to land on tails the next time. This is totally incorrect. The odds of it being tails are exactly what they were the first five times: 50-50. Each flip occurs separately and independently of the others. It doesn’t have to land on tails. And just because the market has been up or down the past several days doesn’t necessarily mean it has to do anything one way or the other.
Hindsight Theory: When we look back over history, we tell ourselves that we knew something was going to happen before it did. The internet bubble that burst in 2001 is a powerful example. Everyone now claims that they saw it coming. They just knew that the market had reached unsustainable highs and that the bubble would burst and take all the high-risk investors and day traders to the cleaners.
So if everyone knew in advance, then how come they all lost money? Almost no one admits that they hung around for the whole ride and lost money in the dot-com meltdown, yet millions of people lost billions of dollars in that time frame.
Rearview-mirror Effect: We tend to be most influenced by what has happened recently instead of what is happening right now. As the market goes higher, individuals (and institutions – after all, mutual funds and hedge funds are run by humans) tend to become more and more bullish; when the market has sold off for an extended period, they become more and more reluctant to buy. Yet if I find a great company that meets my criteria, I say that’s all the more reason to buy.
Self-attribution Bias: We have a tendency to congratulate ourselves for our own brilliance when we succeed, but blame outside influences for our failures. When a stock we picked goes up, it is because we are clever and made the right choice. When a stock we picked goes down, it’s the economy, the Federal Reserve, the stupid broker or those gosh-darned hedge funds that made things go wrong. In my office, we refer to this as confusing a “bull market for brains.”
Disposition Effect Bias: One of the worst tendencies of investors is to sell winners far too soon and hold on to losing stocks. The old saying, that you can’t go broke taking a profit, has killed more investor portfolios than Attila the Hun did Romans. If you take 5% to 10% profits on your winners but continually take huge losses on your losers, holding onto the belief that it will come back, your overall results will look pretty bleak.
The flip side of selling winners too soon is just as dangerous. I call it “falling in love.” You can show love to stocks, but stocks can’t love you back. When they become too risky, you simply have to sell them and move on, even if they have made you rich.
Familiarity Bias: This happens when an investor focuses on familiar or well-known investments even though more gains can be made through diversification. As a result, this can lead to poor-performing portfolios and a greater risk of losses. Instead, my whole goal with Breakthrough Stocks is to find lesser-known stocks — with much better growth prospects than the “usual suspects” you hear about on TV every day.
Trend-chasing Bias: Past performance does not indicate future success. So, just because a company did well in the past does not mean that that trend will continue. You can kick my Breakthrough Stocks system into reverse, and if one of your small caps ever starts failing to meet my criteria, then it’s time to sell.
As a card carrying member of the human race, I’m not thrilled to report that our brains are such terrible investment tools. But the good news is that computer programs can massively improve our investment performance.
I’m talking about better investing made possible by “following the numbers.”
I’m About to Go Public With My Moneyball Multiplier Challenge
Numbers and stocks are two of my greatest passions in life. Fortunately, I’ve been able to combine them into a long and successful career picking growth stocks, all because of the investment formula I’ll explain in my Moneyball Multiplier Challenge on Wednesday, September 30 at 4 p.m. ET.
Bottom line, I believe that the proof is in the numbers and that analyzing the numbers can help us find stocks with much better growth potential, while avoiding the pitfalls of human bias.
It was pure numbers-based research that had us buying homebuilders in 2002, just as they began a huge multi-year run higher. The very same stock system led me to recommend Google (NASDAQ:GOOGL) in its early days, and Amazon (NASDAQ:AMZN) in 2003, when shares were trading for peanuts. Just $46. Today, they’re trading at around $3,056 per share. That’s a 3,546% increase!
One of the best places I see opportunity right now is the small caps. The best of these companies have way better earnings prospects than the S&P 500. At Breakthrough Stocks, earnings season is just heating up for my companies.
Click here to RSVP for Wednesday’s Moneyball Multiplier Challenge this Wednesday and be there to take part.
Note: The Editor hereby discloses that as of the date of this email, the Editor, directly or indirectly, owned the following securities that are the subject of the commentary, analysis, opinions, advice, or recommendations in, or which are otherwise mentioned in, the essay set forth below:
Google (GOOG), Amazon (AMZN)
Louis Navellier had an unconventional start, as a grad student who accidentally built a market-beating stock system — with returns rivaling even Warren Buffett. In his latest feat, Louis discovered the “Master Key” to profiting from the biggest tech revolution of this (or any) generation.