This post has ended up longer than expected. Thus, I have broken it up to two articles. Stay tuned for part two!
As humans, we are built to think in certain ways, and they are prone to errors. In the investing world, these errors can be very expensive, and being aware of these can help your bottom line.
It is my belief that investment performance is mostly determined psychologically, so here are some psychological pitfalls to be aware of.
The most common example given is the one about World War II planes.
In WWII, too many planes were being shot down. Engineers wanted to know how to increase the chances of planes making it back, so they looked at the “survivors”. What they saw were lots of bullet holes in certain parts of the planes, so they concluded that they should put more armour on those parts. This is the classic example of falling prey to survivorship bias.
What the engineers should have done was put armour on the parts did not have bullet holes instead. Why? Because those planes that were shot in those areas did not come back. The fact that the survivors were shot in certain areas and still came back proved that those areas were not essential.
Survivorship bias in sales jobs like real estate and insurance is very prevalent. Those that did well remain but those that did not left, resulting in departments of mostly successful people. So, if you hear statements from sales directors such as:
“My training/mentorship program is very good, my department is full of people with >$X of sales”
“I am a good leader because all my underlings have been with me for >X years”
now you know better.
Survivorship bias is also present in the stock market. Failed companies become bankrupt or delisted. This also happens in stock market ETFs (since the constituents will change, ‘bad’ companies get kicked out e.g. Noble). When we compare the historical performance of an ETF, we have to be aware that the companies that make up the index is likely to be different from ten years ago. The constituents are also likely to be different ten years later. Can we extrapolate future returns if the constituents are different? Good to know especially for those that buy and hold ETFs.
In this sense, ETFs are like mutual funds as the constituents are picked based on a certain criteria. However, it is still different from mutual funds. Stocks in a mutual fund are picked for their future returns, whereas stocks in an ETF are selected to reflect the country’s overall economic performance.
This pitfall is similar to ‘fake news’, where information is not given with the other party’s best interest at heart. This is due to the incentives of both parties not being aligned.
An example would be a stereotypical insurance agent pushing a certain product because it gives the most commission. Even though it may not be the best product for the client’s needs, it gives the most commission and gets pushed.
We should check the validity of news sources, especially if they are advertising certain counters (they could be pushing up/down the price). Most blogs and articles have a disclaimer whether the author owns the stocks, so we can take that into consideration. However, on forums like InvestingNote and HardwareZone, posts are anonymous (except for verified accounts), so we should probably take them with a pinch of salt.
However, people recommending stocks that they already own can be seen in another way. Since they believe their own analysis, they buy the stock. This can be seen as putting their money where their mouth is, which is a good thing.
Here’s a point of view that may be controversial. Recently there has been a trend towards buying and holding low-cost ETFs for the long term. The fees charged by the funds are on an annual basis, so the longer you hold, the more fees they earn. Nevertheless, for long time horizons (>10 years) and beginner investors, they are very hard to beat.
At the end of the day, you and you alone are responsible for your own wealth and financial future. Please do your own research and due diligence before investing your own hard-earned money.
Since I’ve written about others, it is only fair that I write about myself. If you have noticed, there are no advertisements on this blog (as at Feb 2019). I find advertisements take away from the user experience and will do my best to avoid them. Currently, the hosting/domain costs are easily covered by my dividends, so I do not need to worry just yet.
This is commonly exploited during sales like GSS. We see “80% OFF! UP:
$500 NOW: $100″ and think that it is a steal with $400 savings, without considering that we are still paying $100 for shoes. Personally, I’m using the SAF PT shoes so running shoes are free with Emart credits ($30-40 if no credits).
This effect is also seen in the stock market, where prices may rise or fall by a large amount, and investors get stuck to the old price. Here’s an example:
The price of this stock has risen from $0.8 to $10 in less than two years! That’s 12.5 times! Would you still buy?
If you had bought and held till now, it would have been a 5-bagger. Being tied to the previous price of stocks can cause you to miss out on multi-bagger returns. The same can be said for stocks that drop (e.g. Noble).
We have to be clear on our own investing methodology when investing. Mine is Buffet’s “Price is what you pay, value is what you get.” Even if a stock has risen, I could still get value if the fundamentals are there. This can also be applied to my previous shoe sales example. If you find the shoes worth $100, regardless of the previous price, it is logical that you would buy it.
Stay tuned for part two!