Golf aficionados likely caught the end of the recent British Open in which Adam Scott tragically gave up a four-stroke lead on the back nine. This chain of events caused me to reflect on the fragility of success. As a professional golfer, Scott has no doubt practiced for thousands of hours to refine his skill set. Furthermore, Scott outperformed the entire field in an exceptional performance during the first three and a half rounds.
Success in the financial markets is a difficult task and is likewise fragile. While the impediments to success may be different from the ones that a golfer faces, investors face psychological “traps” that can derail an otherwise sound investment strategy. In particular, the risk of falling prey to confirmation bias and shallow analysis can be dangerous. The confirmation bias is the tendency for people to favor or believe information that supports their current views and hypotheses.
Being intellectually honest about our thesis and rationale for investments is critical to our success. How can we become better investors if our thought process isn’t consistently challenged? Are we taking the path of least resistance in our analysis and analytical rigor? Here are a few signs to watch out for:
- Searching for confirming views: Wall Street Journal columnist Jason Zweig once wrote that “people are twice as likely to seek information that confirms their beliefs than they are to consider evidence that contradicts them.” Do you carefully consider opposing views? Moreover, do you consistently consume the same sources of media and investment literature? Diversity of analysis can be of high value in a day and age when “groupthink” tends to be prevalent.
- Easily shaken by volatility: How can you have faith to ride out short-term fluctuations without the confidence of a fully vetted idea? While there is nothing wrong with having tight stop-loss discipline, it is a whole lot easier to be shaken if you don’t trust the idea. An investment made without a thorough understanding could lead to a rash or emotional decision because you will lack a sound thesis to look past short-term noise and focus on the bigger picture.
- Lack of conviction: What is the point of holding a stock that you don’t have high conviction in? I personally would rather own an index fund than a stock I don’t love. There’s an old saying that a “long-term investor” is one whose holding is currently under water. Investors who are lukewarm on a holding may end up in this camp.
- Loss aversion: Does your original investment thesis still hold? If not, are you holding only because you are reluctant to take a loss? Cut bait and get out. These situations lead to investors taking on more risk because of their loss aversion. Loss aversion is a psychological bias that entails an investor holding a stock in hopes of “breaking even” instead of selling and taking a loss.
Obviously, a well-vetted idea doesn’t guarantee success, but a lack of reasonable diligence is inexcusable. Making money is too difficult to lose it on poor decisions. A whole year of hard-earned gains can be wiped away with undisciplined choices. Take a look at your holdings today and ask yourself why you are still holding them? Do they still meet your original criteria? Investing is difficult enough without some of the aforementioned psychological barriers. Becoming aware of these traps can help lead to greater long-term success.