Consider your investment portfolio. Do you hold stocks (or other securities) in companies that you love? Do you tend to disregard or ignore articles that highlight the bear case for that investment? If yes, you could setting yourself up for a common pitfall when it comes to investing. Falling in love with an investment is one of the worst things an investor can do for overall returns. As humans, it is in our nature to like/love things that are familiar to us. This is not just applicable to stocks or investments, but for everything in life.
I was recently listening to the Masters in Business podcast with Daniel Kahneman. Daniel Kahneman is a world renowned psychologist, best known for his work on the psychology of judgement and decision-making. Even though he is a psychologist, he is a Nobel prize winner in economics (awarded in 2002). His research explained and shed light on why the investing world falls for the same traps over and over. One of his most cited study is the Prospect Theory, which among other things summarized that humans value gains and losses very differently. Losses have a far more emotional impact than equivalent amount of gains. For e.g., losing $5 has a stronger emotional impact on most people than finding $5. The overall psychological impact is charted as shown below from the Kahneman & Tversky study. As noted, the curve falls faster towards the left than it rises on the right, indicating the overall psychological impact.
I highly recommend you listen to the podcast, but if you do not have the time or patience, have a listen starting at the 41:45 mark. As Prof. Kahneman explains, the familiarity of ownership makes humans think highly of that entity. In his words, “Almost everything that is familiar….you like better”.
No Place for Emotions
This is what investors tend to do with their portfolio holdings. As is always the case, its easy to say that investors need to remove emotion from the decision making process, but its easier said than done. It’s ingrained in human nature…there’s nothing wrong with it. The successful investors take a step back, identify the problem, remove emotion from the context and make the right decision. There is no place for emotions when it comes to investing. It is important to identify and keep such things in check. I know I fall for this trap myself and constantly work on identifying such problems and correct my mistakes on a regular basis.
The interesting point about this is that each investor approaches new ideas with a healthy dose of skepticism. When there is no familiarity, you tend to question everything and take an idea apart and are critical. This is a good thing to do. Same kind of criticism should be taken to current portfolio holdings (or even investing style). The path towards complacency is a slow one and catches investors by surprise when the fall eventually comes. You approach a new idea with skepticism, slowly you wade in taking a small risk, you get familiar and realize that your skepticism was unfounded or the reward paid off against the risk taken……after a few months, you become even more familiar and comfortable. Next thing you know you are growing confident and start loving your investment idea until you reach a point of hubris.
I have identified that I was too tunnel-visioned on dividend investing. The monthly and quarterly payments are like a drug giving me a little pleasure regularly keeping me happy. But I was missing the big picture. My thinking was — If I sell my holdings, my passive income will decrease and I will miss my goals. I need to keep buying paying a higher multiple on the stocks that appear safer. I finally decided to take a step back and realize that I was risking a big part of my assets to make 2-3% in income. That’s when I had the awakening and decided that I need to sell and get out of this crazy market. Read the post here.
It is one of the reasons why I regularly talk to Jay from FI Fighter. Not only do we bounce investment ideas off of each, but we also discuss some of the pitfalls that we have faced personally and/or see common in marketplace. On surface, it may seem like his focus changes too quickly from dividend investing to real estate and then to precious metals, but he has avoided those pitfalls of falling in love with one investment strategy. There are numerous ways to achieve financial independence, and falling in love with a single strategy is not one of them. It reminds me of a quote from Charlie Munger: “Any year that passes in which you don’t destroy one of your best loved ideas is a wasted year.”
Most investors tend to fall for similar pitfalls over and over. Only the successful investors identify such issues and take the necessary steps to re-evaluate investment ideas. Falling in love with investment holdings due to familiarity is something that is ingrained in human nature and should be avoided. It is important to treat existing holdings as if it’s a new investment and approach with the same dose of skepticism and criticize the idea as you once did pre-investment. I invite you to make a bull and bear case to each of your holdings and justify on why you are staying invested in that security. If you are honest with yourself, the results may surprise you. I know they surprised me.