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Your finger hovers over the “enter” key – the computer screen’s glow flickers as the price of the stock or fund you’ve teed up to buy jitters up and down.
Your adrenaline and pulse rate are up, your pupils dilated – the price dips and, boom, you take the plunge.
Well before you hit “enter” and trigger this cascade of chemical excitement and release, you should have asked yourself some key questions to make sure you weren’t tripped up by common behavioral investing mistakes.
The pitfalls are many. There are nearly 200 different cognitive decision-making errors you can fall prey to – particularly when committing capital to your “brilliant” new investment idea.
But many errors are just variations on a theme. For a start, learn to avoid the most common and damaging errors by considering these five key questions before you hit “enter”:
- Overconfidence – How much do I know about this company/industry/situation/strategy?
Maybe you got an idea from a Jim Cramer Lightning Round comment, Reddit chat group, or a product you saw in a store. Maybe you had a successful idea in this industry/sector before. You followed up with a little research or you’re going with your gut because this sounds like something you seen before.
- Do you know enough about the dynamics of the company or industry niche?
- Can you easily explain to someone else the mechanism or catalyst that has to happen for your investment to pay off?
You don’t have to be a small-cap, Japanese value stock analyst or consumer products expert to invest in those respective areas. But you do need to know enough to support the logic of your thesis and have a realistic idea of the limit of your knowledge. Otherwise, overconfidence in your own ability to judge incomplete or uncertain information can kill you.
- Herding – Is my idea still somewhat original or is FOMO driving the decision – maybe even a little?
Friends, the financial press, and social media may offer good investment ideas, but they usually come late to the table and amplify trends that are already well established, if not peaking. Technology has done nothing to curb our instinct to follow the herd, or bubbles wouldn’t keep happening. The market dominance of the “Magnificent Seven” stocks demonstrates this, even if their fundamentals are strong. Again, make sure you’ve done your own analysis to help avoid getting swept up in market enthusiasm.
- Confirmation bias – Have I looked for flaws in the thesis or sought contrary opinions or facts?
It is all too easy to only look for the facts or analyses that confirm our judgment. Don’t just focus on information supporting your idea. Yes, it’s reassuring to find opinions that confirm your own judgment and “insight” – but don’t stop there. Seek out the devil’s advocate who believes it is a bad idea and consider their arguments. Refute them if you can or at least consider them – otherwise, your bias will leave you blind to a range of outcomes you didn’t really think about.
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Framing – Am I objectively analyzing the full scope of this opportunity or is my frame of reference skewing how I see it?
The cleanest shirt in the laundry hamper seems like the best option if your frame of reference is the hamper. But that shirt is still dirty. There are always more options and limiting your frame of reference forces you into false or poorly informed choices. Experience with technology stocks, emerging markets, or real estate may frame how you approach (or avoid) these sectors today, but their market dynamics and the global economy have evolved since past major booms and declines. Recently, the S&P 500 index has been on a tear. But when you look at the performance drivers, the “Magnificent Seven” have done all the heavy lifting with the rest dragging. Just focusing on the overall index misses a lot of what’s really going on under the hood.
The framing and context of an investment choice are key parts of a decision but can trip up your judgment if you aren’t prepared to think “outside the frame.”
- Anchoring – Are the numbers I’m using to evaluate the stock idea the most relevant?
Our minds are lazy and want to remember just one or two numbers. We anchor on what we think a company is worth based on the stock’s most recent high. Or we bet on a turnaround in sales growth or profit margins because we just “know” the company can do better – we remember what it did before.
Similarly, home sellers often fixate on past peak valuations despite weak current conditions, seizing up housing markets.
Fixating on a specific reference point without considering current fundamentals or the wider historic range of outcomes can lead to bad valuation judgments.
The draw to hit the “enter” key is strong when you’re in the moment. Keep as much emotion out of the process up to that point by thinking about these questions when you do your analysis beforehand. Once you’ve got your thesis down and questions answered – then let the endorphins fly.
Ted Everett is a CFA and an investment advisor and financial writer in Boston. He helps financial service companies create readable and insightful investment-thought leadership whitepapers and other content. He has edited and written extensively for various investment newsletters. He has also served as portfolio manager and trusted advisor for families, trusts, and smaller institutions and made more than his share of cognitive errors over the years.
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.