As I mentioned in the last chapter, we are driven throughout our lifetimes by several psychological factors that may explain why we aren’t making the right decisions when it comes to buying and selling stocks. In this chapter, I will expand on the need to be liked factor and will introduce two new behavioral factors that affect our decision process—our tendency to be overconfident and our need to comply with our previous commitments.
To be liked or not to be liked: that is the question.
There is a good reason why we are conditioned and almost addicted to the idea of being liked and, furthermore, why we are afraid of not being liked. Remember your school days. Who did you want to be? Did you want to be the kid that was the most popular or the kid no one would speak to? Did you want to come to parties on your own or with other kids? How did you feel about the kid who sat next to the teacher on the annual school trip because no one else wanted to sit next to him or her?
So why do we want to be liked? The simple answer is that life usually works much better for us when we are liked than when we are disliked. As far back as the early days on this planet, humans who got along with and were liked by others generally fared much better than those who weren’t liked. In the beginning of time, taking care of each other was a must in order to survive, and who likes to take care of someone they disdain? It’s very simple; for most of us, being liked means having more opportunities to have good friends, better work, and happier lives in general. Being liked is a great thing. What’s the problem with that?
Consider the following scenario: if you could purchase only one stock, would you be more likely to purchase a stock owned by a group of your friends who recommended it to you or a stock recommended by your next-door neighbor who insists on mowing the lawn when you take a nap? If you chose the second option, what are you planning to tell your friends when they ask about it? Even worse, how will you feel when they brag about the big success they had? There’s not an easy answer.
As opposed to the great benefits of being liked as part of your place in society, making an investing decision based on the level of approval you will obtain as a result is not always a smart move. When making an investment decision, we need to ask ourselves some of these questions:
- What is the value of the company versus its current price?
- What are the company’s future prospects?
- How effective is the company management?
- Do I really know enough in order to make a smart decision? If not, where can I learn more?
We tend to like people who provide us with value and knowledge. Answering the above questions and discussing them with your friends will allow you to make savvier investment choices and will increase your popularity because of the valuable knowledge you possess. In the next chapter, we’ll discuss these questions and meet the famous Mr. Market created by Professor Benjamin Graham. Stay tuned.
Overconfidence and commitment
Do you think most people are confident in themselves? You might find it interesting to learn the following:
- In a study conducted in Sweden by the University Of Stockholm, subjects were asked about their competence as drivers in relation to a group of drivers. It was found that 88 percent of the participants believed themselves to be safer than the median driver.
- Nineteen percent of Americans believe they are among the richest 1 percent in the world.
- Eighty-one percent of new business owners think their own business has at least a 70 percent chance of success, but only 39 percent think that any business like theirs would be likely to succeed.
- The US Census Bureau reports that 50 percent of new ventures close within the first four years.
How would you answer the questions that were asked in the first three studies above?
Confidence is very important in making any decision, and the lack of it can prevent us from making even simple decisions. However, overconfidence—especially overconfidence that is not backed with key facts—can be fatal to your investment results.
On top of being overconfident, we also tend to commit and even anchor to our previous decisions.
Think about the following questions:
- Would you be willing to buy a stock today that was cheaper six months ago?
- Would you be willing to sell a stock you own that is now priced at half the price per share it reached six months ago?
In a 2004 shareholder meeting, Warren Buffett said, “I bought something at $X, and it went up to $X and 1/8. I sometimes stopped buying, perhaps hoping it would come back down. We’ve missed billions when I’ve gotten anchored.” The mix of overconfidence in ourselves and our tendency to anchor and commit to our previous decisions can lead to undesirable results.
What can we do to avoid this? The first step is to acknowledge these traits and not allow yourself to be fooled into believing that you are different. As Richard Feynman said, “The first principle is that you must not fool yourself, and you are the easiest person to fool.”
Other ways to avoid these psychological factors when investing are:
- Before purchasing a stock, write down why you decided to purchase that stock at this price and what factors or changes will motivate you to sell the stock.
- Use checklists to make sure that you have covered (and checked) everything you want to know about a company before making a commitment.
- Keep searching for new information, especially information that does not agree with your theories.
- Admit your mistakes.
What should you check before purchasing or selling a stock? How do you know the value of a company? Why does it take longer for people to plan their vacation than to purchase a stock? I’ll answer these questions and many more in the next chapter.
Excerpted from “Why do we sell low and buy high? The guide you must read before you invest" by Amir Avitzur Copyright © 2012 by Amir Avitzur.
The book is available on Amazon (Paperback and Kindle Edition) – http://www.amazon.com/Why-sell-low-high-ebook/dp/B007O45LAO