In this world of constant news flow and rapid access to financial data, it’s easy to forget the difference between investing and trading. Many amateurs (and most professionals for that matter) seem to confuse the two concepts, engaging in a strange hybrid of the two philosophies.
“Trading and investing are based on two very different philosophies. Investors purchase and sell when a stock deviates from its intrinsic value. Traders, on the other hand, take their cues from price action…Problems arise when people integrate trading concepts in an investment approach” Frederik Vanhaverbeke, Excess Returns
The problem is that investors often get lured in by the siren-sound of the trading world. There is good reason for this – our brains are wired to look for patterns and make predictions. Succumbing to a trading mentality provides our brain with the dopamine hit it craves. And once we get a taste for that excitement, it’s hard to give up. We forget that profitable investment should be boring
The worst “trading habits” typically sit at the intersection of these three dangerous psychological biases:
Pattern Seeking is a powerful bias because it evolved as a survival instinct. Being alert to anything out of the ordinary was crucial for pre-historic man. Whether it was identifying a threatening animal in the long grass, or a potential meal on the horizon. A false positive wasn’t a big deal – after all there is no downside to finding out that you only imagined that lion (except a little embarrassment among your fellow hunters). So we’re wired to be over-sensitive – to piece together small fragments of information and to create a pattern out of nothing.
In financial markets, you’ll find traders looking for patterns and trends in everything. A whole language has grown up around this habit of pattern-seeking. If you find yourself thinking about Closing Ranges, Coppock Curves or Bullish Homing Pigeons, my advice to you is to stop right there. Most likely you’ve been sold on something that is designed to appeal to your natural pattern-seeking instinct. In my experience, it rarely helps you to be a better investor.
Recency bias is our tendency to attach too much importance to recent events and less importance to events further back in time. Combined with our tendency for pattern seeking, it can lead us to extrapolate recent trends to a much greater extent than we should. If a company has beaten earnings expectations four quarters in a row, we imagine it should continue to do so.
It’s also recency bias that leads us to credit a stock or company with “momentum” . Momentum is a valuable concept in physics, but it’s massively overused in financial markets. A mass traveling at speed has momentum, and will continue in the same direction unless opposed by an external force (one of Newton’s basic laws). It’s important to remember that stocks don’t possess this attribute! It seems obvious, but a stock moving in one direction at speed isn’t obliged to continue in that direction – it doesn’t possess any innate “momentum”.
This is a bias that causes us to attach too much importance to a small data set, because we (erroneously) believe it is representative of the whole picture. This is part of the reason we overreact to one bad set of results – we assume these results are representative of what the company will always achieve. Equally when we invest in a company that makes one bad deal or one strategic mistake, we quickly conclude the whole organization is entirely incompetent.
These three biases combine to create a dangerous cocktail, and drinking it can lead to some really dumb behavior. We become overly despondent after a couple of bad results, or overly confident after a string of good ones. If you find yourself behaving like this it’s time to check your emotions. Done right, investing should be boring. Sure, it can be an intellectually stimulating pursuit and good investors get a satisfaction from the process. But if you’re after a quick dopamine hit, then investing isn’t for you.
“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas” Paul Samuelson