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Investment Markets are There to Make you Look Stupid

Updated: May 17, 2022

When you make a decision to buy something, whether a stock, a fund, an ETF or a passive fund, you impose on yourself a second decision, namely to sell it. In other words, roughly speaking, you should expect that half your investment decisions would relate to purchases and half, whether the next day or a hundred years from now, to sales. Yet so little time gets dedicated to the practice of selling. Why is this?

"The world of investment is ridden with randomness and uncertainty"

To some extent, it is because of the world around us – the media and most academic literature focuses on buying not selling. The act of buying is a more positive one than selling but it may also reflect the nature of consumption, where we make most of our purchases in daily life. I very much doubt people buy bananas with the intention of selling them unless they run a market stall. Nor does keeping them make much sense.

However, it may also be a function of what is inside us, namely the cognitive and behavioural biases that drive our decisions. Wikipedia lists 175 different such biases. These biases can be thought of as mental shortcuts – we humans only ever have limited information, and biases, also known as heuristics or rules of thumb, help us to reach decisions rather than freezing like the proverbial rabbit in the headlights. However, because they are shortcuts based on limited information, they can often take us the wrong way, hindering instead of helping.

Take overconfidence for example. It is well documented that confident people are more attractive, so it makes sense that we humans evolved the drive to have more confidence in our own abilities than others had in theirs. In the process, however, we exposed ourselves to ‘overconfidence’, the belief that we are better than we actually are. Conning others can be very productive – you may well attract a good-looking mate – but conning oneself can be problematic.

The world of investment is ridden with randomness and uncertainty. Randomness far outweighs pattern. And chaos theory means the future quickly becomes uncertain. As an investor, it is tempting to think after the equivalent of a run of wins on the roulette table, that you are in control. Tempting but fatal. Investment markets are there to make you look stupid.

When we make an investment, we naturally think we have made a good decision. However, if we make the investment without having a plan, then selling can be a very hard thing to do. It may represent an admission of failure, there may be a fear of missing out on future gains, one may worry that one does not have sufficient evidence that it is right to sell, one may have developed an emotional connection with an investment and would feel a sense of loss. ‘Failure’, ‘fear’, ‘worry’, ‘loss’ are negative words that naturally cause us to run rather than confront.

The key to selling is the same as the key to buying: process. If you buy things on the basis of valuation, you should sell on the basis of valuation – knowing what makes something cheap must surely mean knowing what makes it expensive. If you buy things on the basis of quality of management, then you should sell on the basis of quality of management. And don’t wait for the evidence to be incontrovertible – the price will already have fallen.

Finally, do not worry about making mistakes. It may well be wrong to sell, in the same way that it may be wrong to buy. You are never going to get all your decisions right, so don’t try. This is naturally harder to apply when it comes to selling. While burying your head in the sand might prevent you from seeing the headlights, it will not tend to stop prices falling.

Published in Trustnet

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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