In every market cycle, there are those who think "this time will be different," and invariably these individuals are disappointed when the music stops. People buy high and sell low, and then spend years trying to get their portfolio back to where it was before they made that ill-fated decision. How do you make sure that you do not join their ranks?
Seek out those who disagree with you
No one likes being wrong -- that is an integral part of human nature. After all, we assume that being wrong means losing money, and no one likes that. Perhaps more importantly, no one wants to be seen to be wrong, either. And therein lies the problem. Many people, many more than you would think, are so averse to being told that they are wrong that they will do anything to avoid a difficult conversation. This drives individuals to overweight opinions that agree with their own, and to underweight opinions that disagree with their own. Among psychologists, this is known as confirmation bias and it can seriously distort decision-making.
It is a problem not only for the individual investor, but also for the market as a whole. When more and more people succumb to confirmation bias and begin reinforcing one another’s excessive bullishness or bearishness, significant mismatches between price and value occur. Of course, one person’s problem is another person’s opportunity, so if you are able to stand aside from the crowd and not get swept along with the herd, then you can stand to profit. But this requires challenging your own confirmation bias, and seeking out investors with contrary opinions to your own, and being willing to be proven wrong.
Be realistic about your abilities
So these biases can move investors in either direction, but why is it that sentiment seems to be overwhelmingly bullish almost all the time? The answer to that question is also rooted in culture and psychology -- simply put, more people want to believe that tomorrow will be better than today. Again, this is not in and of itself a bad thing. Indeed, without this assumption it is unlikely that we could have developed the concept of lending, as there would be no reason to loan or invest in a venture if you didn’t have a general belief that life could get better.
But this admirable human quality is also what makes most investors skew to the bullish side, and to assume that they are better investors than they actually are. In psychology, this is known as the Dunning-Kruger effect -- a mental bias wherein individuals overestimate their own competence. And, as it turns out, the less skilled someone is, the more they overestimate their own powers. In investing terms, this leads people to expect higher returns from their portfolios than is reasonable.
If you remind yourself that you are probably not as good as you think you are, then you will be less tempted to chase some arbitrary yield in the hope of "beating the market." Just focus on making the right moves, and check in on your performance at the end of the year. You will probably be happier for it.
Disclosure: The author owns no stocks mentioned.
Read more here:Â
Peter Lynch: Improve Your EdgeÂ
Debt-Laden Companies Can Ruin Your PortfolioÂ
Howard Marks: The Importance of Second-Level ThinkingÂ
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