Two Costly Thinking Errors that Derail Investors

Two Thinking Errors that Kill Investment Success

This is from a continuing series from my Book, Mindful Money- How to Overcome the Number-one enemy of Financial Success: Your Brain. Common thinking errors can cost us fortunes if we don’t recognize them. Here are two of the deadliest errors.

Anchoring  

When investing we get “anchored” to a past price, or other milestone for a stock. Then, we talk ourselves into costly decisions. For example, I hear this all the time: “I will NOT get out of XYZ stock until it is back to where it was two years ago.”  This completely disregards what is happening with the stock in the real, current world and is just an arbitrary thinking error that is stuck in your head.

In Daniel Kahneman’s book, Thinking Fast and Slow he talks about two brain systems that we use to determine our entire world.

  • System 1 is the system that “ballparks” everything. It looks at past events quickly to put a value on things happening now. System 1 often uses “rules of thumb” that it has collected over a lifetime, to fall back on when making a decision. These rules are called heuristics and we use these rules for the majority of our decisions. It causes us to jump to conclusions that are often wrong.
  • Kahneman’s system 2 is our more deliberate self. It is contemplative by nature and demands correct figures and logic. This is when we can think logically and free of bias. With system 2 thinking you make a lot of good decisions. This will never be perfect, but the more you understand about your thinking, the more money you will make.

In my experience, investors use System 1 to make most decisions. Many times, they are emotional. The investor may be under a lot of stress. So, he does what he has always done. He self-medicates by trading away one stock for another or he goes to cash. This has never worked before, but he always thinks it will. He now has regret coming on top of other fears. A gambling addict may think just one more trip to the casino will be favorable. A weekend of self-medication at the tables gets him deeper in financial despair. Most people don’t have the problem of being addicted to stock trading. But at times they will act in their own worst interest and panic out and in. No one is immune, even mutual fund managers or worse, hedge fund managers. If I can’t keep you from making emotionally charged bad decisions, then I have little worth as an advisor.

Anchoring can have peculiar effects on our decisions. The mere suggestion of a number can make us anchor to that number, such as the asking price for a house. We give more value to a higher priced one if we have 2 options of equally nice houses.

In Kahneman’s research, he once rigged a wheel of fortune that was numbered from 0-100. He rigged it so that it would stop on only two numbers; 65 and 10.  Students at the University of Oregon were the participants. Researchers would spin the wheel and ask them to write down their number, which of course was 65 or 10.  They would then be asked two questions:

  1. Is the percentage of African nations in the U.N. larger or smaller than you wrote?
  2. What is your best guess for the number of African nations in the U.N.?

The spin of a wheel of fortune cannot possibly yield useful information about the percentage of African nations in the UN! The participants should have simply ignored the numbers, but they didn’t. The average estimate of the students who landed on “10” was 25 nations. It was 45 for those that landed on “65.”  This phenomenon is also part of the anchoring effect because it causes people to place value on a nonsensical fact in guessing about another unrelated fact. If you ask someone if Gandhi died at 114 years old, you will get a much higher estimate of his age at death than when you ask people if he died at 45.

The Extrapolation Error

Extrapolation is an act or instance of inferring an unknown from something that is known. For instance, we know we are 60 miles from a huge cliff. We are speeding across the desert at 60 miles per hour. So, we extrapolate that we will fall over the cliff and die in 60 minutes. That thought could be true, but it is really an instance of the extrapolation error. When we think like this, we don’t think of all the possible outcomes of the situation. That requires system 2 thinking. Many things could happen with your doomed car. You may slow down. You may stop. You may turn around and go the other way.

The investor is the great extrapolator, he extrapolates from his most recent experience infinitely into the future. If the market has been going up steadily it “feels” like it will continue. If the market is trending down, you may feel like it is headed south forever. I hear people say, “I had $100,000 invested 4 years ago and that has doubled. I now have $200,000. In twelve years, I should have 1.2 million dollars.”  Or the opposite when the market has been trending down. “My million dollars became $800,000 in a year. At that rate I will be broke in 5 years.”

Science and Economics have given us some of the most embarrassing extrapolations. Many discredited scientific facts were extrapolated and many of them continue to be believed. The dreaded hole in the Ozone and Acid Rain both turned out to be faulty science falling victim to the extrapolation error. Also, estimates about future temperatures are usually extrapolated from a recent number of years; “the temperature is going up a twentieth of a degree a year, so in a hundred years it will be 5 degrees hotter than it is today.”

There is no room for premonitions, superstition, or feelings in investing. The most common illogical thought is “I knew I should have bought that stock!!” or “I knew that stock was going to tank!!” No, you didn’t, because if you did you would now own the stock that has gone up and you would have sold the stock that has gone down!

People ask me a lot if the market is “going up or going down.” How would anyone know that? The market has done what it has done up until one second ago. What it does in the next second or day or year is unknown. We can make an educated guess about the future prospects of a stock, but it has nothing to do with what it has done up until one second ago. The same goes for real estate, of course.

Keep in mind that current or past events do not predict future events! Don’t be like that lady in Reno, who clutches on to her slot machine because it is “due.”  Each pull of the handle, each roll of dice and each hand played are independent events. Tables don’t get “hot or cold.”  But it sure as heck seems like it!

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See you soon,

Craig

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