What is it that separates a top investor from an average investor? Is it that the top investor is inherently smarter? Does the top investor follow financial news more closely than the average investor? Does the top investor have a better understanding of industry jargon that just goes over the head of the average investor?
The truth is there’s not a definitive answer to any of those questions. And even if the top investor is smarter, reads more, and understands the industry lingo better, those traits pale in comparison to the most important difference: top investors are better at avoiding behavioral traps.
These traps can cause an otherwise rational investor to act irrationally and potentially put their gains at risk.
Behavioral traps are so prevalent that I’ve divided this list into three different articles. In this article, I’ll discuss eight of the most common traps out there and how you can recognize (and avoid) them.
- Familiarity bias. One of the biggest reasons people lose out financially is they stick with what they know, despite much better options available. For instance, you might visit a big-box retailer one week and think it may be a great investment because of how busy it seems. However, this feeling doesn’t mean there aren’t retailers with much better performance metrics, even if you don’t shop there. Familiarity bias also leads us to choose the same things we chose before, even when there are clear signals that it’s not the best option (e.g. Richter & Spath, 2006). The research showing how this bias affects investment decisions (e.g. Samuelson & Zeckhauser, 1988) has been well known for 25 years.
- Confirmation bias. This is the tendency to surround yourself with information that validates your point of view while dismissing any evidence that conflicts with your reasoning. For all you people still watching your Sony Betamax, you know what I mean. (e.g. Festinger & Carlsmith, 1959).
- In-group bias. Madoff investors take note. So-called in-group bias is a manifestation of our innate tribalistic tendencies, resulting in the predisposition to surround ourselves with those who share similar takes on the market. This could mean you literally seek the opinions of people who share your viewpoint or, more likely, that you only read news sources that don’t challenge your views, providing a false sense of security in your individual viewpoints. (e.g. Nemeth & Kwan, 1987).
- Gambler’s fallacy. If there’s one thing that should be ingrained in our thinking as investors it’s that past performance is no guarantee of future results. Yet the “gambler’s fallacy” is falling for the notion that what happened in the past will happen in the future. People frequently think they can see a pattern in random events and then expect those patterns to be more predictable than they actually are. Then they make investment decisions, usually bad ones, based on those expected patterns (e.g. Swedroe, 2012).
- Post-purchase rationalization. After we buy something that’s not right, we convince ourselves that it is right (e.g. Mather, Shafir & Johnson, 2000). Many investors refuse to accept they’ve made a mistake, especially with their largest investments. This leads to the infamous “throwing good money after bad” behavior.
- Ownership effect.This is an offshoot of post-purchase rationalization. It’s why we value things more when we own them (e.g. Cohen et al., 1970). Professional investors avoid developing an emotional attachment to their investments and stay dispassionate. It’s easy to see this in real life. From a deck of cards, draw a single card and hand it to your friend. Then give them a card. Then ask them which card they are willing to trade away to a friend. Guess what? In most cases your friend will retain the card they chose over the card they were given, even though the randomness of each selection is the same.
- Endowment effect. People have a tendency to hold the same types of investments they already own or inherit. For instance, if an investor inherits a large sum of money in Treasury bills, they tend to keep it in Treasury bills, whereas if they inherit a high-risk company, they opt to hold that investment regardless of their risk and return objectives (e.g. Samuelson & Zeckhauser, 1988). To some degree, this helps to explain the curse of the third generation owners of a family business. Rather than diversify toward success, they hold onto what they inherit, often taking down everything that was built before them.
- Observational selection bias. This is the phenomenon of noticing something we hadn’t noticed before and wrongly assuming that the frequency has increased. In reality, your brain has decided to start noticing something to the exclusion of other phenomena. This may manifest itself after you make an investment and suddenly you see and hear about it “everywhere.” All these appear to be signs that support your original investment thesis, sort of like your brain is providing you a confirmation bias without you asking it to (e.g. Stanovich, West, Toplak, 2013). It’s easy to see how this kind of thinking could affect how you see things like coffee makers, 3D printers or even Ugg boots. However, if this is the first year you are noticing Uggs, there is a lot of historical information you are unaware of.
It isn’t that top investors don’t make mistakes—they do. It’s that they recognize behavioral traps exist and are more adept at avoiding them.
One of the easiest ways to work around your individual biases is to work with a knowledgeable advisor. He or she will admit that no one out there knows the future, and remind you that the best way long-term investors can overcome irrationality is through a disciplined investment process and a rational outlook.