The Capitalist Investor - Episode 9

Behavioral finance is an important topic to be mindful of as you manage your portfolio. Misbehavior will cost you dearly. So what do you avoid? How do you make smart decisions? In this episode, Derek and I cover 5 behavioral finance errors to be mindful of—confirmation bias, information bias, loss aversion, the oversimplification tendency, and hindsight bias. Listen to this episode if you want to make smart decisions with your portfolio.

Outline of This Episode

  • [1:22] Misbehavior costs you
  • [2:53] Confirmation bias
  • [4:36] Information bias
  • [7:34] Loss aversion
  • [10:23] Oversimplification tendency
  • [12:30] Hindsight bias

Behavioral Finance misbehavior costs you MONEY

From 1999-2018 a 60/40 portfolio did 5.2% annualized. The average investor over that same time frame did 1.9%. Why such a disparity? Because the average investor sold when there was fear and invested when there was hype about a stock.

Another staggering figure—If you missed the five best days of the stock market, you lost ⅓ of your returns. If you missed 10, you lost ½ of your returns. Those are large numbers, likely because you made behavioral finance errors. So what are the top errors?

#1 Confirmation Bias

Confirmation bias is when you’ve already made your decision. You LOVE Apple products and think they’re a great company, so you look for facts and figures that support your conclusion that Apple is amazing. It’s why so many people invest in IPOs that they shouldn’t—because their product or service is cool, they use it and like it, so they’ve already confirmed in their minds that it’s worth their investment. We really only see this with entry-level amateur investors—but it happens.

#2 Information Bias

Information bias is when you take irrelevant information and make it relevant to justify a rise or fall in the price. We’ll use Tesla as an example: They’ve sold close to 500,000 preorders for their upcoming CyberTruck. Tesla fans will fixate on those pre-sales and use it to justify purchasing their stock. A rational investor will look at those pre-sales and focus on the fact that they are $100 refundable deposits. It doesn’t mean 500,000 people will actually buy a truck. Many may just take their $100 back.

#3 Loss-aversion

Everyone knows the rule of thumb, “nobody makes money by buying high and selling low”. But sometimes, you need to cut bait and take a loss. Everyone is more willing to sell something and take a win than sell at a loss. But if you’re holding on to a true loser, you need to kick it to the curb. We have exit strategies for everything and if the stock goes in the wrong direction—we move on. It’s better to allocate your portfolio to winners, not dogs.

#4 Oversimplification Tendency

Your average investor oversimplifies the stock market and how to value stocks. We often see people sit on $500,000 instead of investing it because they’re too fixated on the PE ratio being too high. Sure, it may be high in 2019 but could drop in 2020. We value stocks by looking at their management team, their growth story, and their valuation. You can’t base your strategy on one answer you got from the internet.

#5 Hindsight Bias

Hindsight is always 20/20. You can’t be a Monday morning quarterback.

A question we were asked this year is how we missed Apple. We didn’t miss it. We both had Apple in our strategies. We NEVER could have predicted that they’d be up 100%. We have a risk-management process and hold the best possible risk-adjusted stocks in the right percentages. It doesn’t make sense to have a high concentration in one position. Keep listening as we take a deep-dive into why we didn’t allocate a higher percentage to Apple.

Listen to the whole episode to get in-depth information on each particular behavioral finance bias and how they could impact your strategy negatively—and how to keep that from happening.

Resources & People Mentioned

Connect with Derek Gabrielsen

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Show Notes by

Keep Listening to The Capitalist Investor:
Episode 15:
Spending Strategies in a Bear Market, Ep #15
Episode 31:
Handicapping the 2020 Election, Ep #31
Episode 47:
11 Investments in Your Home That Pay Off, Ep #47
Episode 63:
Jeff Bezos and Amazon: Past, Present, and Future Ep #63
Episode 79:
7 Ways Biden Plans to Tax American Families (Part II), Ep #79
Episode 95:
5 Beaten Down Stocks to Buy on the Dip, Ep #95
Episode 111:
Special Episode – Talking Energy with Daniel Turner, Ep. #111
Episode 127:
Retail Earnings Tank & What The Heck is Greenflation? Ep. #127