Todays guest post is written by Paul Andrews, who runs thecodetoriches.com. The Code To Riches is dedicated to, “Presenting personal finance advice in a way that’s as close to hilarious as possible without being offensive. JK, sometimes we’re offensive.” Head on over to his site to let him know what you think!
I subscribe to the theory that says that mistakes aren’t bad things. Actually, I don’t know if it’s a theory or not. All I know is that it’s a lot easier to know that you can’t fly by jumping off a roof then by simply reading up on human flight. The blisters on my hand help send a very clear and understandable signal that in fact, no, I can’t touch that pan yet. And when my credit cards/social security number/phone number are being used to make several illicit purchases, it becomes obvious that I DON’T have a wealthy Nigerian uncle who just died.
The goal for today is for you, dear reader, is to avoid making 4 extremely common behavioral finance mistakes. My hope is that I can save you from a terrible fate (losing money) by explaining to you the natural mistakes that most retail (regular) investors make in the market.
In other words, I’m going to be telling you that you can’t fly, the pan is too hot, and you have no family with ties to African wealth, so you don’t have to learn the hard way. Christ, I’m a nice guy…
The Four Most Common Behavioral Finance Mistakes:
Markets are tricky creatures. They’re difficult to understand, incredibly hard to predict, and impossible to control. Yes; they’re exactly like your ex. The issue with the stock market is that it presents arguably the simplest method for making money that exists. Buy a stock low, sell it higher, make a profit.
But don’t confuse “simplicity” with “ease”. Just because the concept is simple doesn’t mean that anyone can be a successful stock trader. In fact, therein lies most of the behavioral finance mistakes that people will make: they assume “simple” means “easy”. The four main behavioral finance mistakes most retail investors make are:
2) Biased Judgement
3) Herding Mentality
4) Loss Aversion
Don’t be “a-FREUD”; this stuff might sound sort of technical psychological jargon-y, but it makes a lot of sense once you dig into it.
… yes, you’re welcome for the pun. 🙂
We, as humans, have a natural tendency to be overconfident in our abilities. What abilities, specifically, you might ask? Well, pretty much name anything and there will be examples of people thinking they’re faster/stronger/smarter/better than they really are.
For example, take the classic experiment where a group of participants are asked to rate they’re driving skills in comparison to the average driver on the road. Almost every participant thought they were a better than average driver (which is, by definition, impossible).
Along the same lines, what about the research of Frenchmen that shows that 84% believe they are above average lovers? Or that 68% of the faculty at the University of Nebraska think themselves in the top 25% for teaching ability? Or another study where 60% of male respondents thought themselves in the top quartile of athletic ability?
Clearly, humans have a really bad tendency to “toot our own horn”, so to speak.
So how does this play out in the world of finance? The first obvious application comes to stock trading. Which no one in their right mind would ever consider doing if they want to be wealthy. But for those of you that decide to partake in the futile activity, know that you’re more than likely WAY overestimating your ability to trade successfully. And I’d be willing to bet that those of you having an adverse reaction to that challenge are probably more over-confident than most.
See?! You’re just making my point.
But this overconfidence doesn’t just stop at the trading floor. What about your confidence in your ability to find good deals? What about your negotiation skills? Or your networking abilities? Do you find yourself believing you’re above average?
If so, chances are you’re not. So do yourself a favor: take yourself down a peg. Really try to evaluate your skills/abilities objectively. And ALWAYS try to keep improving, be it becoming a better coupon-cutter or a better negotiator!
Unfortunately, biases have been hard wired into our brain. Tens of thousands of years ago, biases allowed us to make snap judgement calls that prepared us to fight or run away. These biases helped keep us alive, and as such were passed down in the gene pool.
These biases don’t go away, even when presented with statistical information that proves otherwise. For example, take ten flips of a coin. The odds of getting all heads is the same as getting all tails, which is the same as getting HHHHTTTTTT, which is the same as getting TTTTTHHHHH, which is the same as getting HTHTHTHTHT. So when a statistics professor tells a class of 30 students to write down what they think the exact order of 100 flips of a coin will be, but tells one student to ACTUALLY flip the coin and write the sequence, walks out of the room, comes back when the flipping is done, the professor is able to tell which person actually flipped a coin.
How? Because the professor knew that there was a general bias in the human mind against guessing too many heads or tails in a row. Even though the odds of all heads was the same as alternating heads and tails, people are more comfortable guessing the more “random” set.
Biased judgements are also the reason that many state lotteries allow participants to choose their own numbers. Even though the “tax on idiots” participants have absolutely no control over what numbers are chosen as winning numbers, when they’re allowed to guess what will be picked, they’re more likely to participate in the game.
How does this appearance of control occur in the world of finance? Well, you have absolutely no control over what happens in the stock market. Even your predictions have no correlation to being correct. You can talk about it all you want, but you did not know whether or not Britain was going to exit the EU. You don’t know how the upcoming election will affect the market, if at all. There was a time when a continuing of quantitative easing meant a small spike in the market. Now it’s considered a poor sign for the economy.
But you being allow to participate in the market might give you the feeling that you have some control over it. But you don’t, boo boo. You just don’t.
On the personal finance side of things, how’s your emergency savings doing? Oh, it’s really low because you’re not going to have an accident? Calling bullshit there: you driving as safe as possible doesn’t mean that there aren’t people that think stop signs are a suggestion and yellow lights are a challenge. Not to mention you’re probably overconfident in your driving ability any way…
In order to remedy this, you have to give yourself over to some amount of chaos. You don’t know what outstanding bills you will have, you don’t know what the market will do, you don’t know when your girlfriend is going to go out and spend $300 on “shoe therapy” or your boyfriend is going to go out and buy a Jetski even though you live in Kansas. Give yourself over to a bit of chaos, and plan accordingly!
This is a nasty one, because you’ll feel like you’re doing everything wrong when in fact you’re doing it right. Herd mentality is just what it sounds like: you follow others simply because there are a lot of them doing it. Experiments in herd mentality include, but are certainly not limited to:
- If you put a random person on a corner and tell them to look up at the sky, a few people will stop to see what he/she is looking at. But if you put five people on the corner looking up at the sky, even more people will stop and look up. If you put 15 people on a street corner and tell them to all look up at the sky, around half of the people that walk passed will look up.
- There is a psychologist and seven test subjects. The first six subjects are in on the experiment, the 7th is not. The psychologist presents the subjects with a line, and then offers three more lines as choices. He asks, “Which line choice (A, B, or C) matches the length of the first line I showed you?” The first 6 all answer incorrectly, on purpose. The 7th person would then more than often give the incorrect answer, just due to social pressure.
- Any time you’ve been in a group and everyone’s been wrong but because they all agree you start to think you’re wrong. It used to happen to me all the time in college. Now, I’m just a stubborn asshole! Yay!
There are numerous instances of herding mentality in financial markets. Take for instance, the tulip bulb craze in Holland back in the early 17th century, where Dutch merchants and common folk alike were thrown into a mania about tulip bulbs and their value. At their peak, tulip bulbs were so prized that people were trading land, jewelry, and furniture just to get their hands on one. There was even a sad story about a foreigner who ate a particularly valuable bulb as an onion for his fish. Turns out that bulb could have fed the ship’s crew for AN ENTIRE YEAR!!!
All this for a fucking flower…
Of course, prices came crashing down like Charlie Sheen after a bender. But there are many other instances of asset prices being drastically over-inflated. The Great Depression, the internet bubble, and the housing bubble are all American examples. So why does this keep happening?
Because it’s incredibly hard to ignore when your neighbor, your boss, your secretary, your grandparents, and that loser kid you knew from high school are all making easy money in the stock market while you’re not making anything. So you jump in. And then someone sees you do it, and they jump in. And it becomes this self-feeding loop that inevitably ends in pretty much everyone becoming poor.
But this doesn’t just happen in the stock market. Let’s list all the stupid things people buy because other people have them:
–BEANY. FUCKING. BABIES.
-Those stupid wookie masks because that one lady laughed a lot.
-The Apple _______ (insert Apple Product)
-Clothes. All of them
And the list goes on and on. So do yourself a favor: don’t be a sheep, cow, 14 year-old girl, or anything else that “herds”. Fight the powers that say you must purchase Ugg boots, Snowmobiles, or that Dancing Groot. Don’t let the fact that everyone is in the market be a reason for YOU to be in the market. Stand proud against the herd!
Loss aversion is the reason you won’t approach that cute guy/gal at the bar. Loss aversion is the reason you’d “accidentally” restart your Xbox then lose at a PvP match on Call of Duty. Loss aversion is why sore losers are so much more prevalent than sore winners.
Essentially, loss aversion means that when you take a “loss”, it hurts a lot more than when you “win”. This explains why most investors will sell winning stocks and keep losing ones. After all, you don’t officially take a loss until you’ve sold a stock for less than you purchased it. And humans, with all our flaws and misguidance, would like to think that, “Sure, the stock fell 50%, but it MIGHT go back up.”
Data from the stock market shows us that more often than not, that’s simply not the case. In fact, it’s often better to sell your losing stocks and let your winners “run up.”
But again, these behavioral finance mistakes do not just occur in the stock market. To give you an anecdote, let’s take my recent car purchase. As part of the deal, I had a vehicle I was prepared to trade in. Before I made the giant move from south Texas, I had an offer in Texas for $1,500. Not bad. But my girlfriend and I decided to move the car up to Colorado Springs and take a chance with it up here. Turns out the dealer wanted to give us less than $900 for it.
Now, bearing in mind that I hate car salesmen with the roaring firey passion that permeates my being to the deepest reaches of Hell, I wanted to tell the car salesman to suck my… well… you know. But with the amount of time/$$$ it would have taken to get the car repaired so I could sell it to a private party, it just wouldn’t have been worth it. So we cut our losses and sold it to the amazing *cough* raging asshole sleezeball *cough* salesman.
Behavioral Finance Mistakes – The Wrap Up
No, we humans are not perfect. After all, we’ve created the Jersey Shore, Vegemite, porn, the atom bomb, and those stupid-ass running shoes with the space for your toes. We touch things we’re not supposed to, do what we’re told specifically not to, and ingest things that ought not to be ingested.
But the key is to make sure we learn from our mistakes. In the finance world, we do this so we stand a chance of becoming financially secure. Please learn from the following mistakes, the VAST majority of people will make when it comes to finances:
- Overconfidence – Always check yourself before you wreck yourself. Are you REALLY that good of a trader? Are you SURE you’ve found the best deal? Science says, “NOPE”
- Biased Judgement – Check your objectivity. Are you buying Disney stock because you’re “literally obsessed with princesses and shit”? Don’t assume emotional investment means you have control. You don’t!
- Herding mentality – Cows herd. Sheep herd. Goats herd. You’re not a cow, sheep, or goat. Don’t herd. Man up and come to your own conclusions.
- Loss aversion – Cut your losses early and often. Finance teaches us that it’s much better to move on to a new prospect at the club when a hunk/bae has turned you down then to spend all night drunkenly slurring through your words trying to convince the poor girl/bastard that you, “Opened for Ozzy once…”.
Do you find yourself making these behavioral finance mistakes? Do you think you’re somehow impervious to these behavioral finance mistakes? What, you think you’re so awesome that you can just go through your financial life just doing whatever you want because you’re some sort of super-strong, quick witted Chris Angel Mind Freak? Huh? HUH?!
Sorry, I got a little upset….
And as always, keep trying to crack the code,
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