❝Rip Van Winkle would be the ideal stock market investor.❞ -Richard Thaler
Sean walks over to take a look at an order that just came in. It's 1999, and we are cooks at a local family restaurant. It's pretty slow, so it's just the two of us working. Sean works two jobs, including this one. His other job is at Walmart. I just recently read an article about how Walmart employees receive stock options. I have a surface-level interest in investing and get really excited when I read stories about Walmart employees who got wealthy because of their Walmart investments. Similarly, I feel a mixture of excitement and envy when I read up on people who were early investors in Microsoft. I live paycheck to paycheck, and I think about the day when I can become wealthy by being an early investor in some company.
Five years later, I'm working at a bank talking with Peter, my friend and co-worker. He is reading a personal finance magazine that lists the mutual funds that did well over the past year. I find myself looking at these funds with the same mixture of excitement and envy then I felt before. I look at these fund returns, and some of these funds have more than doubled in the last year. Again, I find myself dreaming about the days when I can invest in funds that double my money in a year. Then all I have to do is keep doing that, over and over again. That sounds fun!
Almost 20 years later, I look back and see the error in my thinking. Overnight millionaires are not the norm. The future is unpredictable. Yet this is what so many people, like myself in the past, believe investing is.
It took a decade and a half for me to unwind what I thought investing was. I now understand that investing can feel intimidating to newcomers who believe what I used to believe - that investing is an exciting place where you make money quickly. I also understand how easy it is to fall into the cycle of trying to strike it rich and failing over and over.
Although investing can be simple if you do it right, it's not very easy.
BUY LOW, SELL HIGH CONDITIONING
Many of us are taught that investing should be exciting. It should be about putting our money towards some investment that will double, or even triple, in a short amount of time. It's easy to find stories about overnight millionaires. Any time spent on a financial news channel will have you thinking that it's easy to tell when it's time to sell your stocks. The message is that investing is like gambling but easier and less risky. All you have to do our find winners before they are winners.
Therefore, we are conditioned from a young age to believe that buying investments when the price is low and selling those investments when the price is high is not only possible, but also the best strategy. Then, we're told, we simply repeat that process over and over again.
Unfortunately, it's never that easy. This process has a name, and it's called market timing. Market timing is trying to time the market by getting your money in before it goes up and taking your money out before it goes down. Nobody can do it. And everybody knows that. That's why, in recent years, people who sell this kind of strategy have rebranded it as tactical asset allocation, which is just a jargony confusing word that means market timing.
Market timing is a myth. It's a myth because it is impossible. To start, it sounds easier than it is. But it doesn't take much looking under the hood to find out that it's not enough to be right once. You can't just think that the market is too high and sell. You have to be right again and be able to get your money back in before the market rebounds. And it's even more complicated than that because you not only have to be right about whether the market is too high or too low, but you have to have the timing right. We can be in a bubble for years before it pops. That simply means that everybody can know prices are too high but that knowledge isn't enough without knowing exactly when the market will drop.
We are conditioned to believe that successful investing is about market timing, and market timing is impossible. But this is not the only thing we have going against us.
OUR BRAINS AREN'T WIRED FOR INVESTING
Not only do we have the pursuit of something impossible implanted in our minds, but we also didn't inherit the necessary skills for investing, or personal finance for that matter. Twenty or thirty generations ago, the people who saved what they had for later, didn't follow the tribe, or didn't do something when there were signs of danger did not survive to become our ancestors. We inherited survival skills, which are almost the opposite of good investing skills.
The field of behavioral finance has found many common ways in which we misunderstand investing. There are many, but I'll highlight some of the more common ones below.
Negativity Bias: Negativity bias says that we have a tendency to take in negative information. We will remember all the scary and bad things that happened while at the same time ignoring all the things that are going well for us. This can even take the form of taking a negative interpretation of something good that happened to us. To understand why we have this bias, think about what needed to happen for your ancestors to survive long enough to reproduce. We can't be right all the time, so if we're going to be wrong, we have to err on the side of caution. For example, if I see a stick, but I think it's a snake and run away, the only thing that happens to me is that I get embarrassed. However, I get to survive until tomorrow to be embarrassed again. On the other hand, if I see a snake and think it's a stick, then I might be in big trouble. We simply had to pay more attention to the negative. Unfortunately, that does not help us in investing or in modern life.
Confirmation Bias: Confirmation bias happens when we go out looking for support for our beliefs, while never searching for support for ideas that are opposite of our beliefs. We are likely to notice when we hear or spot confirming evidence. Disconfirming evidence is going to fall on deaf ears, though. We don't even notice it. This runs deeper than simply looking for evidence of our view of what the stock market is doing. This is why we tend to choose friends who agree with us and don't befriend people with different views. Confirmation bias happens when you set filters on your news feed to show you what you want to see and not show you uncomfortable things. Because of confirmation bias, we are unlikely to have a complete view of what's happening, so we end up making investment decisions with partial information.
Status Quo Bias: Status quo bias refers to our tendency to prefer the familiar to change, even if change is better for us. Status quo bias is the reason people who don't want to smoke anymore continue smoking. Because of status quo bias, our default option is to stay the same in the face of compelling evidence to change. It takes around 5 reasons to change for every reason to stay the same before doing something. Please note, this is in no way suggesting that we need to do something all the time. This is simply to acknowledge the fact that we are hardwired to prefer familiarity. Change scares us.
Hindsight Bias: Hindsight bias happens when, after the fact, we know why some event in the past happened. It's only because of the new information that the event makes sense. You can see this if you go back and look at newspaper articles from 2008 or the dot-com crash. Many "experts" can tell you exactly why the markets crashed. Hindsight bias is the reason they couldn't tell you about it before it happened. It's the reason we think the future is more predictable than it is.
Illusion of Control: The illusion of control is the feeling of authorship that doesn't exist. Market timing is textbook illusion of control. It feels like we can control what happens with our investments. However, the future is not predictable. The feeling of control we have is an illusion.