Imagine that you are in a meeting room with your colleagues and brainstorming over a marketing plan. You had prepared well for this meeting and had come with an excellent idea. You are sure that it’s a great idea and your colleagues will really like it and praise you for coming up with it. But you are sadly mistaken. On presenting your idea in the meeting, you get a very different response. Instead of acceptance and applause, your colleagues end up rejecting it due to some flaws in the idea which you had overlooked in your enthusiasm. So, what do you do? Do you accept that you were wrong and change your views easily? Most of the times the answer would be ‘No’. You hang on to your idea by the scruff of its neck and try to convince your colleagues that it could still work however somewhere deep down you realize that these flaws may lead to your entire plan going awry. You tend to present your case and justify the idea based on threads of information.
Sadly, we also replicate this behavior of ours in the stock markets. Obviously the stakes are higher here. Maybe the meeting might get extended by a few minutes because of your insistence to stick to your views. But in the stock markets, this behaviour can make you lose your hard earned money and make you end up in tears!
What is the problem here?
1) We stick to our views:
We do this mainly because we think we know the topic very well and understand it better than the others. Also what about the large amount of time and effort we have spent in forming these views?
2) We do not learn from our mistakes:
We do not analyse the outcomes of our stock investment decisions to find out where we went wrong and how we can improve our mistakes. First let’s see what we do when the outcome of our decisions is proved to be right.
We like to take credit when proved right, even when we may have been right only due to good luck. Imagine a scenario, you invest in Company ABC at price Rs. 100 and say that the stock price will increase to Rs. 150 by the end of the current financial year. You invest in this by seeing the probability that the rainfall will be good for this year. Unfortunately, the rain gods do not oblige and the rainfall turns out to be poor. However the price of the stock still increases to your expected level of Rs. 150 because of some new orders the company received. In such a case, we tend to ignore the fact that that our reasoning was completely wrong and rejoice in the fact that we were right about the outcome!
And we blame something or somebody else for our mistake, when proved wrong. Consider the same scenario as mentioned above. Now suppose by the end of the year, the rainfall was decent though not at par to your expectations and the price of the stock decreases to Rs. 50. We would tend to justify this by blaming the rain gods for the insufficient rainfall rather than finding a fault in our own analysis which may have overlooked some company specific negative factors.
It is important that we know how many times we were right because our reasoning was correct and how many times our reasoning was wrong. Have a look at the matrix outlined in our blog: ‘Don’t forecast future stock prices, Analyze a Company’s ability to earn future profits’ to help make things clearer.
What should we do to overcome these problems?
1. When facts change, change your mind
This can be best understood by the following example – Ten years back investing into a newspaper stock would have been a good idea, but today with the internet boom the younger generation is more inclined to reading the news on the web than the newspaper. Thus, it might no longer remain a good investment as the future prospects seem hazy and the market dwindling. But as we have seen, we are very reluctant when it comes to changing our views, especially in the stock market. And the best way to overcome this bias is to keep our minds open to change. There are two approaches that help us the best in our endeavor:
a) Imagine having zero positions: Start afresh. Ask yourself the question that with the current information available to you, would you buy more of the stock. If yes then the investment is still good, but if the answer is no, it would be best to sell that particular stock.
b) The Devil’s advocate way: Ask a friend to review your investments and critically review your decisions. You can also ask him/her to become the devil’s advocate and intentionally present an opposing view. Your job then is to convince him/her otherwise. This method would be more useful when the person is one who disagrees with you the most (maybe your spouse) or has a more critical way of examination.
2. Keep a record of your reasoning
Maintain a written record of all the investment decisions you take and why you took those decisions. This would help you to hold true to your thoughts at the time of decision making and you would not get swayed by incorrect views which you may form based on the outcome of your decisions. This is a simple but effective way to learn from our mistakes.
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