For investors, self-defense often means simply avoiding stupid mistakes. It’s winning by not losing. Here are a few thoughts on how to do it.
Have you ever bought a stock based on your “gut feeling” that the company was a winner? You assumed that the stock price was bound to go much higher when other investors started to recognize what you can plainly see. We often are tempted to buy stocks because we think we see something that others haven’t yet seen. We think we know something that others don’t know.
Maybe you work in the same industry, so you think you know more than the average person about how to recognize winners. After all, didn’t Peter Lynch, the superstar manager of Fidelity Magellan Fund, once say that investors should “buy what you know?”
Lynch argued that having a job in the furniture business, for example, meant that you probably know more about furniture stocks than most investors, and therefore you had an “information advantage.” The problem is that the edge you have cuts both ways.
Your “insider” knowledge of your industry gives you a better sense of how the industry works, but it can also give you a false sense of confidence in your ability to pick winning stocks in that industry.
Nate Silver, the statistician and author of the best selling book “The Signal And The Noise”, commented recently about the problem of overconfidence. Silver explained that the reason so many “experts” get things wrong is, in large part, because they are experts.
In other words, they know too much. And because they spend so much of their time thinking about their field of expertise, they sometimes confuse their personal views with facts.
“Most things are fundamentally too complicated to easily guess the outcome,” Silver explains. Overconfidence “causes us to discount the risks and plunge ahead, only to find out later how wrong we can really be.”
Does this mean that you should never buy stock in one particular company? Not necessarily. But long-term investors should understand that the “gut feeling” they have, about a company that’s part of the industry that they understand well, is really only about 50% knowledge. The other 50% is probably pure emotion.
Certainty is an emotion, and it’s one that can cloud your judgment and blind you to risk. Anybody who has ever bought a stock at “the bottom,” and then watched in horror as it kept on falling, knows this feeling all too well.
“How could the market be so wrong?” you think to yourself, “Why don’t other investors understand how great this company is, and how ridiculously cheap the stock is?”
The “market” may not know what you personally know. But it also doesn’t know what you mistakenly believe to be true.
The best way to put your “gut feeling” to work for you in a constructive way is to consider it a “leading indicator” of the need to investigate further. Listen to your instincts about a stock, but always resist the urge to act on instinct alone. Ask yourself how much you could lose if your instincts turn out to be wrong. Ask yourself how likely it is that you alone are correct about the company, and thousands of other investors are wrong.
By combining instinct with further research, you can reduce the number of emotionally-driven investment mistakes that you make. This alone will make you a better investor.