Q. How can I tell if I’m about to make a mistake when investing?
A. The most important thing you can do when buying individual stocks is to have a systematic approach you believe in and use consistently. Another way to avoid mistakes is by understanding investors’ common psychological biases. Here’s an example:
Together a bat and a ball cost $1.10. The bat costs $1.00 more than the ball. How much does the ball cost?
If you answered 10 cents, you choose the most intuitively obvious answer. It’s also wrong.
That question highlights one of a handful of psychological biases that work against investors. A relatively new field of study called behavioral finance examines those biases, including:
1 – Loss aversion. The pain we feel from selling a stock at a loss outweighs the pleasure of selling that stock for a gain of the same amount. When you are deciding whether to sell a stock, ignore the price you paid for it.
2 – Anchoring. All of us have the unfortunate tendency to rely too heavily or ‘anchor’ on specific numbers. Psychologists can easily change the results of simple questions, such as, “How old do you think Clint Eastwood is?” by posing an earlier unrelated question containing a completely irrelevant number, like, “What city is 70 miles south of us?” Don’t get fixated on selling only at a certain stock price.
3 – Confirmation bias. People have an innate tendency to feel smarter about a decision after others confirm it was a good one. Whether or not other people agree with you, though, is irrelevant to investment returns, and it can be harmful.
4 – Recency bias. Most people tend to assume that events of the recent past will continue on into the foreseeable future. The effect of a short-term change in a company’s fortunes can be easily over-exaggerated in the stock market. Thinking long-term when investing helps you avoid this tendency – and take advantage of it, too.
And the correct answer to that question above is that the ball costs five cents. Yes, really. Email me for more.