From a financial point of view: Warning: common mistakes lurk nearby | Local News
Originally, we wanted to answer the question of what are the most common investor mistakes that we strive to protect you from as a fiduciary financial advisor. We quickly found ourselves pulling and pushing the yin and yang of traditional (rational) economics and behavioral economics.
Let’s start with the low and tempting fruits of the fallacy – hot hand, player price, and sunk cost to name a few. These common investor mistakes can sound familiar as their impacts resonate across behaviors and contexts.
Think Lebron James, whose hot hands are on a streak of over 1,000 straight games (regular season only) scoring 10 or more points per game. Is it tempting to bet that his streak will continue? In his next game? Season?
Spin quickly to 1913 Las Vegas at the Monte Carlo Casino, where players lost millions by continuing to bet on red while the ball of the wheel continued to land on black 26 times in a row.
Or remember WeWork’s failed IPO in 2019 when the company’s valuation fell from $ 47 billion to less than $ 10 billion almost overnight … despite the $ 18.5 billion that Softbank and its assets had flowed into the company?
The hot hand and player fallacies represent two different sides of the same coin, straddling each side of an inaccurate understanding of probability. Hot hands overstate the momentum of a hot streak while players undervalue the independence of statistical probabilities.
A bet on James’ warm hand streak must consider whether a game is at home or away, which is the component or a change in team dynamics, as these additional factors influence their performance. In Monte Carlo, players mistakenly assumed that the red landing changes increased as the black streak lengthened – they did not sufficiently factor in statistical independence.
These inaccurate valuations and their assumptions can be extended to the performance of a stock, industry or fund manager. Both errors regard past performance as indicative of future results, whether it is a continuation or reversal of the previous one.
Take a break here and write down. Past performance is no guarantee of future results.
Our third familiar mistake is sunk cost. This melody takes advantage of the phrase “no pain, no gain”. By playing on our brain’s perception of the pain of loss twice as great as the reward of gain, we may be tempted to continue to sink capital in the hope of turning the tide and recouping the costs.
Return to Softbank’s dilemma as WeWork lost 89% of its value between September 2019 and September 2020. Reinvesting in the hope of recovery or stopping before digging the hole deeper?
They chose to double the stake by replacing then-CEO and co-founder Adam Neuman with Sandeep Lakhmi Mathrani, titular real estate director, as an example of continued investment. While the change in strategic leadership is supposed to be a positive market signal, their business model remains challenged by a post-COVID remote working reality. Time will tell if the sunk costs will reverse the trend and recover the investments.
In summary, common investor mistakes create rational deviations allowing overconfidence, confirmation bias, illusion of control, recency bias, and retrospective bias (Chen, 2019). These biases enter our decision-making process at the expense of due diligence and adherence to a predetermined investment thesis.
So what is it all about? Why should we care?
Now let’s take a step back and return to the foundations of two critical economic theories: traditional economics and behavioral economics. Financial advisers interweave the fabrics of traditional economics and its rational assumptions with the observed reality of behavioral economics and its impact on decision-making – both of their investors and their investments.
You see, the point is, behavioral economics ‘factor’ and its biases are inevitable. There is even growing research and support for the legitimacy of our gut analyzes and gut reactions. However, financial management and investment decisions must be made on the basis of traditional economics and its rational observations and assumptions.
As financial advisors, we help you navigate the yin and yang of these two forces to identify and unlock opportunities for your portfolio that are aligned with our investment thesis and your financial goals and preferences.
When the GameStop (GME) share price has seen a multiple of 17 times in just 15 days or when Tesla’s (TSLA) stock has jumped 685% in 2020, we stop and take a break for collect information. We take a look at the technical characteristics of a business and take a look at market fundamentals to gauge the actual desirability versus the hype.
What are the traditional indicators and benchmarks to which we can return? What “human” factors or uncontrollable forces should we take into account? To what extent is stock performance supported by brand loyalty, competitive advantage, or proven executive leadership?
Please note that all data is for general information purposes only and does not constitute specific recommendations. The opinions of the authors do not constitute a recommendation to buy or sell the stocks, the bond market or any security contained therein. Securities involve risk and fluctuations in principal will occur. Please research any investment thoroughly before committing any money or consult your financial advisor. Please note that Fagan Associates, Inc. or related persons buy or sell securities for themselves which they also recommend to clients. Consult your financial advisor before making any changes to your portfolio. To contact Fagan Associates, please dial 518-279-1044.