How To Be A Better Investor
Most people think investment success is about finding opportunities before anyone else, or gaining some informational or analytical advantage. Sure, maybe a few people can develop an edge by doing those things, says billionaire investor Chamath Palihapitiya, but “if you define certain behavioral principles that protect you from the worst parts of your own psychology, that’s a winning strategy.”
Investment success is less about what you know, and more about avoiding the psychological pitfalls that lead to bad decisions. This is true for most of us, even great investors like Chamath. That’s because the human brain is not wired for investing, and if you don’t protect yourself from certain hardwired behavioral tendencies, there’s not a spreadsheet or forecast that will help you.
In this piece I describe seven psychological pitfalls that lead to bad investment decisions, and seven tips on how to mitigate them.
Why Smart People Make Bad Investment Decisions: Seven Psychological Pitfalls
“The investor's chief problem – even his worst enemy – is likely to be himself.” – Benjamin Graham
Your brain represents something like 2% of your body weight, yet uses about 20% of energy your body expends. As a result, the brain develops shortcuts to eliminate unnecessary processing, thus conserving precious energy for analytical thinking and complex problem solving. These mental shortcuts and snap-decisions are part of our intuition.
Intuition is useful for making decisions that have a high probability of being correct without having all the relevant information. It’s also useful when speed matters more than precision. An example is when you see a hooded stranger lurking in a doorway and you make a quick decision to cross the street.
Professionals who function in high-stress, high-uncertainty environments rely heavily on intuition. A firefighter may decide to exit a burning building based on an instinctive sense for when it might collapse, an intuitive response developed through lots of experience.
While intuition works most of the time, sometime it doesn’t – especially when mental shortcuts are applied out of context or to relatively new things where our brains are not well-adapted, like financial markets.
In the hooded stranger example, the decision to change course may have been a reasonable judgement. Yet that same thinking applied to investing can lead to poor judgement, like selling stocks out of fear at the bottom of a bear market.
Thanks to behavioral finance, a new field of study that integrates psychology with economics, we know much more about where investors are prone to flawed decision making, including these seven areas which seem to give investors the most trouble.
Pitfall #1: Overreacting to Losses
“The key to making money in stocks is not to get scared out of them.” – Peter Lynch
Research shows that the pain of losing is psychologically about twice as powerful as the pleasure of gaining. Financial losses are processed by parts of the brain responsible for the pain network, so it’s no wonder why we react so strongly when we’re losing money.
Example 1: Lowering your exposure to stocks after seeing a quarterly decline of 10% in your portfolio.
We tend to focus in on short-term losses in particular, even when we know they are likely to be blips in our long-term performance. This short-term focus can cause us to reduce risk more than we should. One study shows that investors who got more frequent information about their investment performance, and therefore observed more short-term losses, took the least risk and had the lowest returns.
Example 2: Not wanting to sell an investment that has declined in value until it gets back to the price you paid.
Realizing a loss can feel like confirmation that we’ve made a mistake. Yet the price we paid for something should be irrelevant in our decision of whether to sell it. When confronting this issue, try asking yourself “would I buy this investment now if I did not already own it?”
Example 3: You want to invest, but the market is up this week, so you hold off until the market comes back down to last week’s level.
We tend to fixate on an arbitrary reference point and give that value a higher weight in our decision process, a behavior related to loss aversion. In Example 2, the price we paid for something shouldn’t be a factor in deciding whether to sell. In Example 3, there’s no reason a prior valuation should be relevant if we expect that our investment will go up in the future.
Pitfall #2: Relying Too Much on Recent Outcomes
We tend to overweight the significance of recent events compared to those further in the past. This is one of the hardest tendencies for investors to get their heads around.
Example 1: Adding more money to stocks after a big rally.
Example 2: Lowering one’s allocation to international stocks after they’ve lagged U.S. stocks for a few years.
Example 3: Using a portfolio’s 3-year performance to assess the quality of an investment strategy.
Recent outcomes are reliable indicators in many facets of our lives. If a restaurant serves you 3 bad meals in a row, it’s probably a good decision to eat elsewhere the next night out. But 3 years of financial performance gives us very little information about the future or quality of an investment strategy.
That’s because financial markets exhibit a great deal of randomness over short periods, and in the short term it’s hard to differentiate between luck and skill. Even great investors like Warren Buffet have extended periods of underperformance, and it takes years, if not decades, to separate luck from skill when assessing the quality of one’s investment decisions.
Pitfall #3: Being Drawn in by Narratives
For thousands of years stories and narratives are how humans made sense of the world. Stories are particularly helpful in areas of high complexity, like financial markets.
Example 1: Believing the news headline “Stocks fall because the IMF warns of a slowdown in global economic growth.”
Example 2: Buying a stock touted by Jim Cramer on CNBC’s Mad Money.
News agencies and investment firms try to capture our attention with stories that explain why a certain company might have excellent prospects, or why the market is performing a certain way. Meanwhile, there are many different factors that influence financial markets, and a story that was probably created to catch our attention can draw us away from rational thinking.
Narratives can be particularly attractive when they come from experts or people we hold in high regard. One study shows that financial experts were right only 47% of the time about the market’s direction – worse than by chance. Even America’s favorite stock picking expert Jim Cramer underperforms the market according to a study of his picks.
Pitfall #4: Investing in What Is Familiar or We Have Affinity Towards
We favor things that are familiar, we view positively, or reflect our values. This tendency helps us feel safe and secure in many aspects of life such as relationships, but could cloud our judgement as investors.
Example 1: Buying the stock of a company because we like their product or service.
Remember the Blackberry? I thought that was the ultimate device 20+ years ago, and so did every one of my colleagues. But I’m glad I resisted the temptation to buy the stock, which declined 95% from its 2008 peak. There are many factors beyond product affinity that determine a company’s success.
Example 2: Holding a large position in your employer’s stock because you know a lot about the company.
During my 20 years at Citigroup I held on to most of my options and stock awards, only to watch the stock fall from $50 to $1 during the financial crisis. My knowledge of Citi lead me to discount the risk, and I learned firsthand how affinity and familiarity can give you a false sense of confidence as an investor.
Example 3: Preferring to own stocks of your home country and foregoing the benefits of diversification.
This example is so prevalent among investors, it has its own name in the research: home country bias. And it’s not just U.S. investors afflicted by this tendency. Whether it be investors in Japan, Germany, Canada or Brazil, we all tend to forego the benefits of a globally diversified portfolio and invest mainly in stocks of our home nation.
Pitfall #5: Being Lured by Complexity
“Everything should be made as simple as possible, but not simpler” – Albert Einstein
No matter what we’re buying, nothing impresses us more than features, jargon and complexity. We tend to believe that when faced with complicated problems, complex solutions are superior to simple ones.
Example 1: Choosing several mutual funds instead of one that meets your objective more efficiently.
Example 2: Being drawn to a complex alternative investment or strategy without understanding it.
While investing can indeed be complicated, investment solutions don’t always need to be. For example, you don’t need a lot of mutual funds or complex investments like hedge funds to build a solid portfolio. Yet financial firms often cater to this tendency by offering complex products that you simply don’t need.
We see this with institutional investors as much as we do in retail. In a study of nonprofit endowment funds, the larger endowments underperformed the smaller ones, which the researchers attribute mostly to higher levels of complexity and associated costs in the larger endowment portfolios.
Pitfall #6: Overestimating Your Own Abilities
People have a tendency towards overconfidence, which helps us succeed in certain aspects of life, like achieving social status. We tend to overestimate everything from our driving abilities and how skilled we are at our jobs to how capable our children are. But this optimistic tendency can get us into trouble as investors.
Example 1: Holding a large position in a particular company and discounting the risk.
Example 2: Trading in and out of the market as a way to improve returns.
Example 3: Investing based on one’s own forecasts of future economic data.
Be careful guys. Research shows that we are more susceptible to overconfidence than women, resulting in a tendency to trade more, underestimate risk and have lower returns.
Success in another field can also lead to overconfidence. For example, doctors have a reputation for being bad investors. That’s because unlike fields such as medicine and engineering, success in investing requires an understanding of human psychology, and how you behave is more important than what you know.
A pitfall that goes hand in hand with overconfidence is our tendency to search for and assimilate data that confirms our beliefs while overlooking evidence that contradicts them. Academics call this confirmation bias. People with high IQs are particularly susceptible to this bias, as they’re better at assimilating data that supports convictions than the average person.
Pitfall #7: Fearing That You’re Missing Out (FOMO)
“A genius is the man who can do the average thing when everyone else around him is losing his mind.” —Napoleon
We tend to fear not being in the know and missing out opportunities, and our deciding not to participate feels like the wrong choice. We follow the crowd instead of our own analysis as a result.
Example 1: Feeling compelled to join in on an investment that your friends are all making money on.
Example 2: Buying an investment mainly because it keeps going up in value.
Napoleon’s wisdom applies neatly to investing as it does the battlefield. FOMO, or the fear of missing out, can give investors an unfounded sense of confidence that is hard to resist.
Example 3: Panic selling during a stock market downturn
The urge to follow others is as strong, if not stronger, when markets go down and panic selling builds.
You can see how these pitfalls can interplay and bolster one another, like here in Example 3 when loss aversion can intensify our tendency to follow the crowd.
Seven Tips for Being a Better Investor
“Investing isn’t about beating others at their game. It’s about controlling yourself at your own game” – Jason Zweig
Here are seven tips to help mitigate these tendencies and, as Chamath puts it, protect you from the worst parts of your own psychology.
Tip #1: Understand Your Weaknesses
Take time to educate yourself on decision making and investing psychology. I’ve included a few reading recommendations at the end of this post. Identify which tendencies give you the most trouble by thinking about investment mistakes you’ve made in hindsight, which tendencies played a part, and keep those top of mind. Being self-aware and able to call out these tendencies can alone give you an investment edge.
Tip #2: Put It in Writing
Everyone should have a written framework for making investment decisions. We write one for every client that we call an investment policy statement. If you don’t already have one, pick a format that works for you, and define things like your investment goals, target asset allocation, and investment process. You could even specify your own particular biases and how to address them, such as what you will (and won’t) do when you’re experiencing FOMO. Refer to this document whenever you’re feeling the need to make an investment decision.
Tip #3: Find an Accountability Partner
We tend to make better decisions when we are answerable to someone else. Whether it’s a good friend, spouse or investment advisor, pick someone who you can confide in, knows you well, and is able to dedicate the appropriate amount of time and attention. Then share your written plan and check in with them before making any key decisions.
Tip #4: Tune Out the Noise
Realize that news and commentary are for the most part created to grab our attention, not to educate us, and can trigger these unhelpful behaviors. Take a moment to reflect on what’s a useful amount of media consumption, select a few objective sources, and tune out the rest. Eliminate exposure to financial entertainment shows and websites that make market predictions, such as Bloomberg, CNBC and Motley Fool, and substitute with healthier sources of entertainment.
Tip #5: Don’t Look at Your Portfolio Every Day
It can be tempting to look at your investments, especially when there are there are big moves happening in the market. Resist the temptation to check your portfolio balance online or you’re your quarterly performance on your statement. Delete the portfolio app on your phone. Remember that it takes years, if not decades, to assess the quality of an investment strategy, and that looking at your performance frequently is not helpful to a long-term investor.
Tip #6: Keep Things Simple
Regardless of the size of your nest egg, simple is almost always better in the long run. If you invest in things you don’t understand or your process is too complex, you probably won’t be able to stick with it long term. Instead target the “Einstein” portfolio, i.e. one that’s as simple as it can be, but not simpler. Understand everything you own and sell any holdings that are duplicative or don’t play a complementary role in the portfolio (considering tax consequences of course).
Tip #7: Manage Your Emotions
When markets are on the move and your emotions are running high, refer back to your written plan. In all likelihood you’ve already anticipated the volatility or behavioral tendency that is causing your emotional response. Check in with your accountability partner if you are considering a make a change to your plan, and sleep on any decisions you do decide to make. Never make rash decisions.
When it comes to investing, how you behave is more important than what you know for most investors. Yet most investors focus on less attainable ways to gain an edge. While it takes some effort, understanding the psychological pitfalls that lead to bad decisions and internalizing ways to mitigate them will give you a distinct edge over the average investor, and is your most accessible path to investment success.
Here are three books on behavioral finance and decision making that I’d recommend. If podcasts or videos are your thing, you can google the authors and find interviews about their work.
- Thinking, Fast And Slow by Daniel Kahneman – a deep dive into how our brains work and why we make the choices we do from the godfather of behavioral finance.
- Thinking in Bets: Making Smarter Decisions When You Don't Have All the Facts by Annie Duke – my favorite book on decision making that is helpful not just as an investor, but in life and business. Especially helpful for those rely too much on recent outcomes (pitfall #2).
- The Psychology of Money: Timeless lessons on wealth, greed, and happiness by Morgan Housel – full of insights and practical takeaways about how people act around money by one of the brightest new financial writers.