It has been three years since the S&P 500 has declined 10% or more from a recent high. Including dividends, the index has more than doubled in the past five years. The Dow Jones Industrial Average has 32 record highs this year alone. Even the Nasdaq is less than 6% away from its dot-com bubble peak.
But high returns breed complacency and create a false impression of how easy investing can be.
That makes it a great time to review some fundamental — if overlooked — investing truths. Here are 16 important ones I’ve learned.
— All past market crashes are viewed as opportunities, but all future market crashes are viewed as risks.
If you can recognize the silliness in this, you are on your way to becoming a better long-term investor.
— Most bubbles begin with a rational idea that gets taken to an irrational extreme.
Dot-com companies did change the world, land is limited and precious metals can hedge against inflation. But none of these stories justified paying outlandish prices for stocks, houses or gold. Bubbles are so easy to fall for precisely because, at least in part, they are based on solid logic.
— “I don’t know” are three of the most underused words in investing.
I don’t know what the market will do next month. I don’t know when interest rates will rise. I don’t know how low oil prices will go. Nobody does. Listening to people who say they do will cost you a lot of money. Alas, you can’t charge a consulting fee for humility.
— Short-term thinking is at the root of most investing problems.
If you can focus on the next five years while the average investor is focused on the next five months, you have a powerful edge. Markets reward patience more than any other skill.
— Investing is overwhelmingly a game of psychology.
Success has less to do with your math skills — or your relationships with in-the-know investors — and more to do with your ability to resist the emotional urge to buy high and sell low.
— Things change quickly — and more drastically than many think.
Fourteen years ago, Enron was on Fortune magazine’s list of the world’s most-admired companies, Apple was a struggling niche company, Greece’s economy was booming, and the Congressional Budget Office predicted the federal government would be effectively debt-free by 2009. There is a tendency to extrapolate the recent past, but 10 years from now the business world will look absolutely nothing like it does today.
— Three of the most important variables to consider are the valuations of stocks when you buy them, the length of time you can stay invested, and the fees you pay to brokers and money managers.
These three items alone will have a major impact on how you perform as an investor.
— There are no points awarded for difficulty.
Nobody cares how much effort you put into researching a stock, how detailed your spreadsheet is or how complicated your options strategy is. For many people, a diversified buy-and-hold strategy is the most reasonable way to invest. Some find it boring, but the purpose of investing isn’t to reduce boredom; it is to increase wealth.
— A couple of times per decade, investors forget that recessions happen a couple of times per decade.
When recessions come, stocks tend to plunge. This is an unfortunate, but perfectly normal, part of the process — like a Florida hurricane. You should get used to it. If you are unable to stomach declines, consider another investment.
— Don’t check your brokerage account once a day and your blood pressure only once a year.
Constant updates make investing more emotional than it needs to be. Check your brokerage account as infrequently as necessary to prevent you from becoming emotional about market moves.
— You should pay the most attention to the investor who talks about his or her mistakes.
Avoid those investors who don’t — their mistakes are likely to be worse.
— Change your mind when the facts change.
Admit when you are wrong. Learn from your mistakes. Ignore those who refuse to do the same. This will save you untold investing misery.
— Read past stock-market predictions, and you will take current predictions less seriously.
Markets are complicated, and human emotions are unpredictable. Unless you have illegal insider information, predicting what stocks will do in the short run is unimaginably difficult.
— There is no such thing as a normal economy, or a normal stock market.
Investors have a tendency to want to “wait for things to get back to normal,” but markets and economies are almost constantly in some state of absurdity, booming or busting at rates that seem (and are) unsustainable.
— It can be difficult to tell the difference between luck and skill in investing.
There are millions of investors around the world. Randomness guarantees that some will be wildly successful by pure chance. But you will rarely find an investor who attributes his success to luck. When you combine a market system that generates randomness with a belief that your actions reflect your intelligence, you get some misleading results.
— You are only diversified if some of your investments are performing worse than others.
Losing money on even a portion of your portfolio is hard for some people to swallow, so they gravitate toward what is performing well at the moment, often at their own expense.
Bull markets - behavioral biases
It’s funny what a bull market can do to our brains.
James Osborne, president of Bason Asset Management in Lakewood, Colo., recently met with a new client who benefited handsomely from the nearly six-year upward run by stocks.
The client balked at cutting his stake in one stock after it had grown to more than half his portfolio, even after Mr. Osborne explained the risk of not diversifying.
Asked if he would put half his money into the same stock if he was building a portfolio from scratch, the client said of course not.
“He saw these gains as ‘house money,’” Mr. Osborne says.
Money earned passively in the market, rather than from toiling at work, can feel easier to gamble with. It is a dangerous bias psychologists call the “house-money effect.”
The client ultimately diversified, “but the behavioral bias of the house-money effect was very powerful,” Mr. Osborne says. “This is what happens after bull markets.”
Here are five others.
The backfire effect. This is a powerful bias that causes us to double down on our beliefs when exposed to opposing viewpoints.
“We think this response occurs because people respond defensively to being told that their side is wrong about a controversial factual issue,” says Brendan Nyhan, an assistant professor of government at Dartmouth College, who has studied the backfire effect in politics.
“In the process of defending that view, they can end up convincing themselves to believe it even more than they otherwise would have if they had not been challenged,” he says.
The same flaw can run wild in investing debates.
If you are convinced that we are in a lasting bull market, how do you feel when you hear someone say that stock valuations are historically high, or that we are overdue for a correction?
If you find yourself so critical of opposing views that you become even more convinced the bull market will last, watch out. Once your priorities shift from determining the truth to blindly defending your original views, you have lost the ability to think rationally.
Confirmation bias. This flaw causes us to seek out only information that confirms what we already believe.
Access to financial opinions has exploded in recent years, thanks to the rise of Twitter and blogs. That is generally a great thing. More smart investors are speaking their minds than ever before.
But it can be dangerous, because no matter what you believe—and no matter how wrong those beliefs may be—you can likely find dozens of investors who agree with you. Having other people confirm your views may cause you to become more convinced that those views are correct.
Charles Darwin had a knack for obsessing over information that disproved his own theories. Investors should try to do the same.
Anchoring bias. This phenomenon causes us to cling to an irrelevant piece of information when estimating how much something is worth.
Your opinion on how much a stock is worth may be anchored to how much you paid for it. If you paid $100 for a share of Apple stock, you are probably more likely to think shares are worth more than $100 than another investor who paid $80 for the stock.
But the market doesn’t know how much either you of you paid for the shares. And it doesn’t care what either of you think is a fair price. Markets will do as they please, regardless of what price you are fixated on.
Recency bias. This one is simple: It is another term for the tendency to use the recent past as a guide to the future.
People like patterns. If stocks have just gone up, the natural tendency is to assume they will keeping going up—at least until they go down, and then we assume they will keep going down.
The S&P 500 fell 37% in 2008, and investors pulled more than $300 billion out of stock mutual funds from January 2009 to December 2012, according to the Investment Company Institute, a mutual-fund trade group.
Stocks have since had a blistering few years, and investors put $205 billion back into stock mutual funds from Jan. 1, 2013, to Dec. 3, 2014.
Markets move in cycles, but people forecast in straight lines. That is recency bias, and it is particularly dangerous after a long bull market.
Blind-spot bias. This—the most dangerous investing bias—is a flaw that causes us to think the biases described above affect other people, but not ourselves.
In his book “Thinking, Fast and Slow,” psychologist Daniel Kahneman wrote that “it is easier to recognize other people’s mistakes than your own.”
That’s something to think about as you analyze your own investing behavior.
James Osborne, president of Bason Asset Management in Lakewood, Colo., recently met with a new client who benefited handsomely from the nearly six-year upward run by stocks.
The client balked at cutting his stake in one stock after it had grown to more than half his portfolio, even after Mr. Osborne explained the risk of not diversifying.
Asked if he would put half his money into the same stock if he was building a portfolio from scratch, the client said of course not.
“He saw these gains as ‘house money,’” Mr. Osborne says.
Money earned passively in the market, rather than from toiling at work, can feel easier to gamble with. It is a dangerous bias psychologists call the “house-money effect.”
The client ultimately diversified, “but the behavioral bias of the house-money effect was very powerful,” Mr. Osborne says. “This is what happens after bull markets.”
Everyone wants to assume they can think rationally. But with bear markets now a fading memory—and with volatility roaring back this past week—now is an important time to understand the common behavioral biases that cause investors to make regrettable decisions during bull markets.
The backfire effect. This is a powerful bias that causes us to double down on our beliefs when exposed to opposing viewpoints.
“We think this response occurs because people respond defensively to being told that their side is wrong about a controversial factual issue,” says Brendan Nyhan, an assistant professor of government at Dartmouth College, who has studied the backfire effect in politics.
“In the process of defending that view, they can end up convincing themselves to believe it even more than they otherwise would have if they had not been challenged,” he says.
The same flaw can run wild in investing debates.
If you are convinced that we are in a lasting bull market, how do you feel when you hear someone say that stock valuations are historically high, or that we are overdue for a correction?
If you find yourself so critical of opposing views that you become even more convinced the bull market will last, watch out. Once your priorities shift from determining the truth to blindly defending your original views, you have lost the ability to think rationally.
Confirmation bias. This flaw causes us to seek out only information that confirms what we already believe.
Access to financial opinions has exploded in recent years, thanks to the rise of Twitter and blogs. That is generally a great thing. More smart investors are speaking their minds than ever before.
But it can be dangerous, because no matter what you believe—and no matter how wrong those beliefs may be—you can likely find dozens of investors who agree with you. Having other people confirm your views may cause you to become more convinced that those views are correct.
Charles Darwin had a knack for obsessing over information that disproved his own theories. Investors should try to do the same.
Anchoring bias. This phenomenon causes us to cling to an irrelevant piece of information when estimating how much something is worth.
Your opinion on how much a stock is worth may be anchored to how much you paid for it. If you paid $100 for a share of Apple stock, you are probably more likely to think shares are worth more than $100 than another investor who paid $80 for the stock.
But the market doesn’t know how much either you of you paid for the shares. And it doesn’t care what either of you think is a fair price. Markets will do as they please, regardless of what price you are fixated on.
Recency bias. This one is simple: It is another term for the tendency to use the recent past as a guide to the future.
People like patterns. If stocks have just gone up, the natural tendency is to assume they will keeping going up—at least until they go down, and then we assume they will keep going down.
The S&P 500 fell 37% in 2008, and investors pulled more than $300 billion out of stock mutual funds from January 2009 to December 2012, according to the Investment Company Institute, a mutual-fund trade group.
Stocks have since had a blistering few years, and investors put $205 billion back into stock mutual funds from Jan. 1, 2013, to Dec. 3, 2014.
Markets move in cycles, but people forecast in straight lines. That is recency bias, and it is particularly dangerous after a long bull market.
Blind-spot bias. This—the most dangerous investing bias—is a flaw that causes us to think the biases described above affect other people, but not ourselves.
In his book “Thinking, Fast and Slow,” psychologist Daniel Kahneman wrote that “it is easier to recognize other people’s mistakes than your own.”
That’s something to think about as you analyze your own investing behavior.
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