Why Do We Make Stupid Investment Decisions?

There is an excellent conversation detailed on the Farnam Street website between Shane Parrish and Adam Robinson about stupidity[i]; in particular, why we make decisions that seemingly lack intelligence, common sense or both.  I was particularly taken with the definition used for stupidity:

“Stupidity is overlooking or dismissing conspicuously crucial information.”

This clearly has resonance when we consider investment decision making – although financial markets are awash with randomness and uncertainty, there are obvious, vital and, often simple, cues that as investors we seemingly choose to ignore or disregard.  This results in poor choices and often disappointing outcomes.

We know that buying assets or funds after unusually strong performance is typically a bad idea, yet we still do it.  We understand the challenges of short-term trading and the benefits of long-term compounding, but can rarely resist the urge to react to what is happening right now.  These issues are not hidden from our view and they are paramount to our overall investment outcomes yet we often neglect them – but why?

Robinson notes seven factors, which can create situations where stupidity can flourish.  I consider each of these from an investment perspective below, whilst adding two additional issues, which I believe can also lead us toward ‘sub-optimal’ investment decisions:

Outside circle of competence: Economists predicting equity market moves, stock picking fund managers pontificating about macro-economics, amateur investors day trading.  There are seemingly no boundaries in investment – if you are involved then you can (and must) have a view on every aspect.  Investing is difficult enough without making decisions in areas in which you have no discernible skill, or where there is no evidence of anyone exhibiting consistently high levels of skill.

Stress:  If we engage with the constantly shifting narratives and random price fluctuations of financial markets it is almost inevitable that pressure and anxiety will lead us into decisions that are detrimental to our long-term goals.

Rushing or urgency: The hyperbolic and frenetic reporting around financial news means that we often feel the urge to act immediately.  We make decisions that will make us feel good in the very short-term, but come with a significant long-term cost.

Outcome fixation: The problem of outcome bias is particularly pernicious in financial markets – this is because of the inherent level of randomness in results (particularly over short-time periods) which means that sensible decisions can often appear quite the reverse. Sometimes stupidity is rewarded.

Information overload: There is simply too much noise in investment markets.  It is a struggle to work out which information is relevant (the vast majority of it is not) or how we should use it.  Given the sheer volume of data, our tendency is to react to it in an unpredictable fashion – considering information to be pertinent based on its salience, prominence, or availability.

Group / social cohesion: We often make investment decisions in a group context, and what other people are doing matters greatly to us.  Even if their judgements are seemingly irrational we will often seek to conform.

Presence of authority (expertise): Perhaps in no other field do we behold such an array of experts.  Each offers confident forecasts and compelling trade ideas – they are intelligent and confident, surely we should follow them?

Overconfidence / Ego: We are often aware of the crucial information, but do not believe it applies to us.  Even where the odds are stacked against us, we feel we have an uncanny ability to overcome them.

External justification: For professionals to justify their role and fees we must be seen to act frequently, being a busy fool is often more highly valued than ‘doing nothing’.

There is possibly no more fruitful setting for stupid decisions than financial markets.  Not only does the decision making environment lure us into mistakes, but the feedback we get is erratic.  Stupid decisions sometimes work and work enough to keep us coming back (like a slot machine giving you enough small wins to keep you interested). Furthermore, for every sensible investment rule there are inevitable exceptions – survivorship bias and tiny samples (n=1)  make us believe that either the evidence is erroneous or that we are the exception. We are not.

[i] https://fs.blog/2019/01/how-not-to-be-stupid/