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:

Investing-Should-be-Boring

Pattern Seeking

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

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”.

Representation Bias

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.

Conclusion

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

Tom Beevers is CEO of StockViews, an online community for fundamental analysts and investors.

Join the conversation! 4 Comments

  1. […] I explained in my post last week, a successful investor needs to understand that investing and trading are two separate […]

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  2. Reproduced here and on LinkedIn:

    Hi Tom,

    I love the weekly posts, which are fantastic in terms of clarity of thought and breadth of topic.

    On this post, you say “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.”

    I tend to agree. As an extension, let’s say a company makes a series of decisions you don’t agree with (say acquisition, plant expansion, or highly dilutive equity raising), and when combined with other factors (say valuation, or point in the business cycle), lead you to shun it (or even the entire sector) and move on.

    However, at some future point the investment proposition improves (say new management comes in, divests certain assets, and pays down debt using surplus cash flow; or perhaps the business becomes so badly ‘hated’ by the market it just becomes too compelling ignore). But if you’re not still looking – perhaps an accumulation of earlier ‘scar tissue’ – you personally may not notice the improvement. But more canny or perhaps naïve investors do, and the share price begins to move.

    It is the process of staying cognisant of an improvement in fundamentals, subtle or otherwise, and in doing so overcome an earlier decision (rightly or wrongly) to deride the particular company (or sector), that I find rather hard to do!

    Am I the only person that struggles with this switch? I guess the key is to keep an open mind.

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  3. Thanks for the kind words Mark! You raise a very interesting question here and I’m very aware of this issue having experienced a similar struggle myself on many occasions. I suspect this has to do with another type of bias altogether – “confirmation bias”: We (humans) look for confirmatory evidence that our original decision was the right one. I wrote about this briefly in a post a few months back (https://blog.stockviews.com/2015/01/09/slaying-your-emotional-demons/). In the case you describe, we sell the stock and then look for evidence to confirm that we were right to sell it. This means that we have a tendency to ignore evidence that the situation is improving (at least initially). Additionally if you made a loss on the stock originally you feel an irrational aversion to going back into that stock (even though the stock clearly has no personality or interest in your whether you made a loss or gain on that stock) An old boss of mine used to say “why would you take a lift from a car that just ran you over?”. This is clearly irrational, but of course it’s also a natural human reaction. The best investors I believe are cognizant of these biases, know that what they are feeling is a natural psychological reaction, and force themselves to think about the decision in a clear-headed manner (easier said than done of course, but the first step is to understand why we feel as we do!)

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    • Thanks Tom!

      Indeed, it is a form of confirmation bias.

      There are a few fund managers here in Australia (Ausbil Micro Cap fund and Wilson Asset Management are two that spring to mind), that have a knack of picking such stocks early in the the recovery phase, while at the same time others previously burnt have long sworn off them.

      In a sense it helps having a fresh supply of young analysts with shorter memories to challenge battle-scarred Portfolio Managers. Says something of the investment process at work to nuture and finely balance such opposing views.

      Mark

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