Everyone likes a good old-fashioned April Fool’s joke. But what if the joke’s on us?
The philosopher Ludwig Wittgenstein once said that nothing is as difficult for people as not deceiving themselves. But while we don’t pay a monetary price for many self-delusions, those relating to investing can come with a hefty price tag.
We delude ourselves for a number of reasons, one of the main ones being our need to protect our own egos. We look for external evidence that supports the myths we hold about ourselves, and we dismiss the incompatible facts.
Psychologists call this “confirmation bias”—a tendency to select facts that suit our own internal beliefs. A related ingrained tendency, known as “hindsight bias,” involves seeing everything as obvious and predictable after the fact.
These biases are evident among many investors every day and are often encouraged by the media.
Here are seven common ways that investors fool themselves:
- “Everyone could see that market crash coming.” Have you noticed how people become experts after the fact? But if “everyone” could see a correction coming, why wasn’t “everyone” profiting from it? You don’t need forecasts.
- “I only invest in ‘blue-chip’ companies.” People often gravitate to the familiar and to stocks they see as solid. But a company’s profile and whether or not it is a good investment are not necessarily correlated. It is better to diversify.
- “I’m waiting for more certainty.” The emotions triggered by volatility are understandable, but acting on those emotions can be counterproductive. Uncertainty is part of investing, and risk and reward are related. Historically, long-term discipline has been rewarded.
- “I know about this industry, so I’m going to buy the stock.” People often assume that success in investment requires a specialist’s knowledge of a sector. But that information is usually already reflected in the price. Trust the market instead and diversify your holdings.
- “It was still a good call, but no one saw this coming.” Isn’t that the point? You can rationalize a stock-specific bet as much as you like, but events or external influences can conspire against you. Spread your risk instead.
- “I’m going to restrict my portfolio to the strongest economies.” If an economy performs strongly, that will no doubt be reflected in stock prices. What moves prices is news, and news relates to the unexpected. Investors often buy into a sector of the market after it has already appreciated. Diversifying across asset classes and regular rebalancing will bring discipline to the process.
- “OK, it was a bad idea, but I don’t want to sell at a loss.” We can put too much faith in individual stocks, and holding onto a losing bet can mean missing opportunities elsewhere. Portfolio structure affects performance.
This is by no means an exhaustive list, but you get the idea: the capacity for human beings to delude themselves in the world of investing is never-ending.
But overcoming self-deception is not impossible. It starts with recognizing that, as humans, we are not wired for disciplined investing.
We will always find one way or another of rationalizing an emotional reaction to market events. And this is one reason that even experienced investors engage advisors who know them and understand their circumstances, risk appetites, and long-term goals. The role of that advisor is to listen to and acknowledge our fears and concerns while helping us forge a more productive path to financial success.