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Why we make investment mistakes

Ray Dalio: "The biggest mistake investors make is to believe that what happened in the recent past is likely to persist."

John Templeton: "The four most dangerous words in investing are: 'this time it's different.'"

Benjamin Graham: "The investor's chief problem – and even his worst enemy – is likely to be himself"

Over the last 20years, I have witnessed, and made, pretty much every investment error under the sun. Some of these would have resulted in significant loss or lost opportunities to gain had I not had the guidance of some excellent mentors over the years.

If I have not put you off trying to beat the market return, our next stop in the journey is understanding common investment mistakes. Rather than go through a very long list of reasons why people make mistakes, I thought I would highlight two key avenues for investment error.

The two key sources of error tend to be errors of i) analysis or ii) psychology. Errors of analysis occur when you have not dug into the investment enough, or been too trusting of third parties. Errors of psychology, are when your internal or external environment skews your objectivity. These two errors are not independent. You are more likely to make analytical errors when the internal and external environment place pressure on you.

Analytical errors

I really do not like the average 'stock tip'. It is often flimsily researched and presented as a sure thing. There is often no lookback to see how the stock tip performed, so it has all the hallmarks of bad decision-making.

The key analytical errors are:

  1. Not doing your own work. Get ideas from people by all means but piling into something wholly on the basis of someone else’s recommendation is dangerous. Generally stock tips miss out on key parts of a recommendation. How long is the horizon for this view? Next week or Next decade? How high is the conviction, and what are the risks to the view? Do you agree with the analysis beneath the recommendation?

  2. Focusing on a base case, rather than a range of outcomes: No-one can predict things perfectly. The outcome of an investment is inherently uncertain. We should consider how our investments perform under a range of scenarios rather than just consider what we expect to happen.

  3. Failure of imagination (and modelling): A lot of big errors come when you have not fully considered all the possibilities of a trade going really wrong (or for that matter really right). Over the last 15 years we have seen a lot of events that were previously considered impossible. Negative oil future prices and negative rates were not considered possibilities. What gets in the way of considering more extreme outcomes is a lack of imagination or the over-reliance on pseudo-scientific modelling (don't even get me started on the normal distribution).

  4. Disregarding fees: Frequent trading and some off-piste investments incur large fees. Are you confident enough in the performance of the investment to bear those hefty fees?

  5. Lack of diversification: Many investors see themselves as having many different investments whereas in the reality they have many stocks that seem to go up and down with the same factors. If your portfolio is always going up and down together, you will end up with big swings, sometimes too big for your appetite. If things go really wrong you will end up taking more losses.

  6. Missing the wood for the trees: When presented with an investment opportunity, it's commonly wrapped in an engaging narrative (i.e. story) highlighting why the investment is appealing. This narrative often includes facts that, while seemingly pertinent, may not significantly influence the investment's performance. For example, the education background of the CEO, or that it's the oldest company in its sector, might appear relevant but often aren't critical unless they directly affect the investment's potential. A compelling story can make people more comfortable with an investment idea than they should be, but there is a crucial distinction to be made. What's plausible, meaning it could reasonably occur, isn't always probable, or likely to occur. These less relevant facts can distract and skew an investor's analysis, leading to overlooking the key factors that truly matter in assessing the investment's potential.

  7. Structure: Much analysis does not fully consider what happens when an asset starts to underperform. This happens as analysis is normally based on starting with a positive view on the investment. The main two effects I see are i) complexity and ii) what happens when you borrow to buy more of an investment otherwise called leverage. We only really know how complexity impacts our returns when things go wrong, and in my experience, seemingly unconnected things can go wrong together when there is more pressure in the system. Leverage is also tough to price. In environments with large volatility, prices can gyrate wildly and people are often forced to dispose of assets at precisely the worse moment.

  8. Misunderstanding of where you are in a market cycle: The assumptions you use often underlie bad analysis. If, for example, the last three years have had very positive returns you might be tempted to extrapolate that effect going forward. The positive environment associated with an upswing in the market cycle can make you feel like this will go on forever, but it won't. It is also true on the downswing that people get very conservative around their assumptions of how that investment will perform going forward, often being surprised to the upside.

Psychological errors

Any regular readers of my blog will know psychological errors are an are of deep interest for me. There are so many of them, and they all link together so I will cover what I see as the main ones:

  1. Greed: Greed in investing tends to happen when you want to get more return from the market than is sensible (or have the stomach for). An example would be trying to get involved in a speculative investment, because it has been in the news for its ascent recently. Greed can make you downplay the downsides and focus more on the upsides leading you to skewed analysis.

  2. Fear: Fear is much like greed in that it skews your analysis. Fear makes people downplay the potential upside and instead focus on the downside. This is unhelpful in investing. We always have a buffet of investments, each with their own upside and downside cases, and if someone is too focused to avoid any chance of a downside, they will also miss upside opportunity. There are a number of people who ‘saw the Global Financial Crisis coming’. That’s obviously great, but did they see the enormous rally in assets that occurred afterwards?

  3. Ego and Envy: An example is someone who sees another fund manager boasting about his or her returns and feels compelled to follow them. This is “FOMO” (fear of missing out) in action. The envy felt about the competitor stimulates your ego. When your ego takes over you might take more risk than is consistent with your strategy and enter into domains you are not equipped to.

  4. Herd following: In investing as in nature, being a part of the herd is extremely comforting. That comfort extends to making investments that currently have good press. The problem is that consensus is often already priced into markets, and therefore companies that people like are already expensive and companies that people do not trade cheaply. Analysis over time suggests that people tend to feel more comfortable adding an investment after it has gone up and everyone has concluded this is a sure bet. This is also true about selling when everyone has concluded this is a lost cause. Whenever I see a chart that has a low point I try and research what the consensus was at that point. Often the consensus is that the asset class is no longer investible. Similarly at high points, the consensus is that the investment’s price will go to the moon. It is hard not to go with a positive consensus as people will be boasting about their returns, the newspaper headlines will be universally positive and you might feel secure that it is all going one way. It is also true that for example in 2009, people thought the oversupply in real estate would mean prices would stay low forever. You were constantly hearing about funds or people who had gone bankrupt through real estate. Acting against the consensus would have taken some courage. I am currently researching how some neurodiverse traits might be an advantage in avoiding herd following.

  5. Losing objectivity on things you own: Whilst beginner investors are known to sell their winning trades too early, I find most of the trouble happens when people fall in love with their investments. This is the "endowment effect" and warps objectivity. Firstly, once people have done their analysis they often feel overconfident about the outcome. i.e. there needs to be a huge change in the situations for them to shift their view on the position. Secondly, even if an investment is going wrong, people are anchored to the price at which they bought the investment. They find it difficult to take a loss. This loss aversion is completely irrational as the price you bought it for matters less than the price today versus the value you see in it. Loss aversion is a real problem for beginner investors. It hits them three ways i) they end up speculating by trying to wait for the price to go about their entry price, ii) they spend more time on this investment as they hang onto it for longer iii) the opportunity cost of spending time on this investment is spending less time on more promising investments.

So what?

  1. To beat the market you need to understand common investment mistakes. Those mistakes tend to be errors of analysis and errors of psychology.

  2. Analytical mistakes include neglecting to explore a range of outcomes, failing to consider extreme scenarios and being swayed by superficial details

  3. Psychological errors involve emotions like greed leading to risky investments, fear causing avoidance of potential gains, and ego driving competition-based decisions.

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