Investing and the Psychology of Self-Deception

Posted on Posted in Mutual Funds

The key to avoiding self-deception is to find an objective way to measure overall performance and then act on the results.

I’ve got to confess. There have been times in my investing career when I’ve been the victim of self-deception. What does that mean? It means that I’ve misled myself into thinking that my investments were better than they actually were.

Self-deception is one of the marks of human psychology. Playing the lottery or gambling are cases of positive self-deception: the illusion that somehow you can overcome the odds that are stacked against everyone else. “I’ll give it one more shot. I have a good feeling about it this time.”

Self-deception works in both directions. For example, social introverts perceive themselves more negatively than the rest of the world. They can be self-deceived into thinking that they and the things they do are worse than they actually are

However, when it comes to investing, the far more common form of self-deception goes in the positive direction. It’s much more comfortable to evaluate a stock’s performance when that stock is doing well and to ignore the stock’s performance when it is doing badly. It’s also a lot easier to only focus on your investing successes while ignoring your failures, without capturing an objective, overall view of your performance.

One of my friends is a very active trader: he likes to throw his money around on the stock market and he rarely buys to hold. He has almost all of his money (about $500,000) tied up in stock investments. Now, with $500,000 you’re not doing a good job at investing unless your 5 and 10 year average annual returns are above 10%.

Unfortunately, my friend is in the grip of self-deception. Last year he lost over $6,000 on his investments. The year before that he only made $8,000. He’s never hit the 10% mark over a single 5 year stretch.

Despite these poor performances, every time we talk he only wants to focus on those few “hunches” that turned out to be winners. He never wants to take an objective, overall look at his investment performance, which is an utter failure. He doesn’t want to face up to the fact that he’s a bad investor.

Investors are human beings. And human beings don’t like to be wrong. But when it comes to investing we really don’t have a choice. We need to be honest with ourselves and do objective investment analysis.

Doing an objective analysis of your investments doesn’t have to be uber-difficult. The key is to detach 1) the time of analysis from 2) the specific performance of your investments. What you need to do is schedule two equally separated days a year to perform a 5 and 10 year analysis of the average annual returns of your combined investments. This will give you an overall picture of your investment strategy.

To get a more micro-grained analysis of each particular investment in your portfolio, simply perform a 5 and 10 year analysis on each separate investment vehicle. Those assets that consistently and dramatically under-perform should be moved into investments that consistently out-perform. Now, there is a danger that you should avoid here and the key word to focus on is consistently. Don’t throw your money into investments that have done well just in the short term and don’t pull your money out of investments that have just done badly in the short-term.

At the end of the day, investors need to guard against self-deception or else the consequences will be visible in terms of the dampening of your wealth. The aim of all investing is to maximize wealth, and if you’re sitting on poorly performing investments, then it’s time to take action.