Want To Score Market Riches? This Is More Important Than Any Stock Pick…

In the past, we’ve talked about how many studies show that investors underperform the broader stock market.

To be honest, that may not necessarily be the worst thing in the world, depending on your situation. We each have our own unique needs and goals, and sometimes they don’t require major gains. Things like capital preservation or income are important in some situations, too.

But what really tends to ruffle some feathers is when I say that most individual investors are bad at investing.

I don’t say this to be deliberately controversial. I say it because it’s what you need to hear, especially in a market like this one.

You see, in a raging bull market like this one, it’s easy to feel like a genius. You hear about a hot growth stock, take the plunge, and then feel like you’re on top of the world when it goes “to the moon”.

I hate to break it to you, but that doesn’t require much extra wattage in the cerebrum. And while big wins are great, part of our job is to not only provide ideas in the form of stock picks — but to help you actually be better than the average investor.

In order to do that, one of the things we have to do is go back to try and understand why most individuals are bad at investing. If we can wrap our heads around that, then we can begin to remedy the situation.

And that’s why it’s important to have an understanding of some basic human psychology. So let’s have a little fun today with a thought experiment. Once you see where we’re going with this, you can keep it in mind as you manage your portfolio. Heck, you can even use this the next time you’re having drinks or dinner with friends. It’ll make for some interesting discussion for sure…

Heads Or Tails: What Would You Do?

First, I’ll present two scenarios. Then I’d like you to think about what you would do in each one.

Scenario 1: Imagine that you have just been given $1,000. You have to choose between two options. With option A, you are guaranteed to win an additional $500. With option B, you are given the chance to flip a coin. If it’s heads, you receive another $1,000; tails, you get nothing more.

Which option would you chose?

Got that? Good, now stay with me here…

Scenario 2: Now imagine that you have just been given $2,000. You must choose between two options. With option A, you are guaranteed to lose $500. With option B, you are given the chance to flip a coin. If it’s heads, you lose $1,000; tails, you lose nothing.

Now which option would you choose?

I picked this up from Gary Belsky and Thomas Gilovich’s book “Why Smart People Make Big Money Mistakes“. I’ve mentioned this book off and on over the years — it really is one of the best books out there on the field of behavioral economics. (I highly suggest you pick up a cheap used copy on Amazon or at your nearest bookstore. It’s a quick read.)

Here’s what they have to say about the two scenarios…

Traditional economic theory used to tell us that the market is made up of rational actors. This means people make rational financial decisions based on the probability of future events. And by this logic, you would be consistent with your decisions in both cases.

After all, if you choose option A in scenario 1 and scenario 2 — the certain gain in the first version or the certain loss in the second — you end up with $1,500 either way. With option B, you have a fifty-fifty chance of ending up with $1,000 or $2,000 in each scenario.

See what I mean? (Go back and re-read this if you need to…)

In other words, the only thing that should matter to you is whether you’re willing to take the certain, but smaller, gain or whether you’re willing to gamble to win more money.

Make sense? There’s just one problem, though…

If you’re one of the rare folks who were consistent with their answers in both scenarios, then congratulations, Mr. Spock. Your cold sense of logic has undoubtedly served you well over the years.

As Belsky and Gilovich point out, though that’s not how most people think. When they tested these scenarios on a group, nearly all of them chose option A in the first (guaranteed to win an additional $500) and option B (lose $1,000 with heads, lose nothing with tails) in the second.

Think about that for a second. Why on earth would they do that? It makes no sense!

The answer is easy. It’s because they’re human…

The field of behavioral economics teaches us about human behavior as it relates to economic decisions. And it suggests that humans are not rational when it comes to finances. This is apparent in the two scenarios provided above. After all, your choices are basically the same in both scenarios. Yet despite this, most people will choose option A in the first scenario and option B in the second. This means humans have a tendency to be more conservative when it comes to booking a sure gain, whereas we’ll take more risk if it means avoiding certain losses.

As Belsky and Gilovich note, this explains why gamblers tend to increase their bets when they start losing money. They’re willing to be more aggressive to avoid finishing the evening in the red.

It also helps explain why most investors sell their winning positions too early and hang on to their losing positions for far too long. The fear of losing money on a stock is far stronger than the joy from achieving additional gains.

The Takeaway

Ask yourself how many times you’ve sold a winning stock just to see it surge another 10%-plus in the days and weeks that followed. On the flip side, think about how many times you’ve held on to a loser just to see it keep falling. As you can imagine, this tendency can have a devastating effect on an investor’s portfolio.

Terrance Odean, another behavioral economist, found that the stocks investors sold went on to outperform those that they continued to hold by roughly 3.4 percentage points in the 12 months following the sale. You don’t need a PhD to understand that, over time, those 3.4 percentage points add up.

If you’re interested in learning more, here’s a short list of cognitive biases from Magellan. If you scan through them, you might be surprised to see which ones you have…

The point is, it’s important to understand our psychological makeup as humans. What’s more, understanding what makes us tick personally is even more crucial. We all have them. And if we work to overcome those tendencies, our portfolios will be on the path to bigger profits.

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