Common Fallacies Lurking Nearby
What are some of the most common investor fallacies to be aware of?
Hot Hands, Gambler’s, and Sunk Cost
Let us begin with the low-hanging and tempting fruits of fallacy — hot hand, gambler’s, and sunk cost to name a few. These common investor mistakes may ring a familiar tune as their impacts resonate across behaviors and contexts.
Think of Lebron James, whose hot hands are on a 1,000+ game streak (regular season only) of scoring 10 points or more per game. Is it tempting to bet his streak will continue? In his next game? Season?
Now pivot quickly to 1913 Las Vegas at the Monte Carlo Casino, where gamblers lost millions when continuing to bet on red while the wheel’s ball stubbornly continued to land on black… 26 times in a row.
Or recall the failed 2019 WeWork IPO when the company’s valuation fell from USD $47 billion to less than $10 billion almost overnight… despite the $18.5 billion that Softbank and its holding companies had sunk into the startup project?
Figure 1: Hot Hand and Gambler’s Fallacies
The hot hand and gambler’s fallacies represent two sides of the same coin, straddling an inaccurate understanding of probability. Hot hands overvalue the momentum of a hot streak while a gambler undervalues the independence of statistical probabilities.
A bet on James’ streak should consider the game location (home versus away), opposing team, and/or any changes in team dynamics as these additional factors may influence his hot hands performance. In Monte Carlo, gamblers incorrectly assumed that the chances of landing on red increased as the black run lengthened. They did not adequately consider statistical independence.
These inaccurate assessments and their assumptions can be extended to an individual stock, sector, or fund manager’s performance. Both fallacies consider past performance as indicative of future results, whether it be a continuation or reversal of the precedent.
Pause here and take note. Past performance is no guarantee of future results.
Our third familiar fallacy is sunk cost. This tune takes advantage of the phrase “no pain, no gain.” This irrationally driven assessment plays on our brain’s perception of the pain of loss as twice as great as the reward of gain. As a direct result, an investor can be tempted to continue to sink capital in hopes of turning the tides and recuperating costs.
Return to Softbank’s dilemma as WeWork lost 89% of its value between September 2019 and September 2020. Do they reinvest in hopes of recovery or to stop before digging the hole deeper? They chose to double down, replacing then-CEO and co-founder Adam Neuman with tenured real estate executive, Sandeep Lakhmi Mathrani, as one example of continued investment. While the strategic leadership change is intended, in part, as a positive market signal, the company’s business model remains challenged by a post-COVID remote work reality. Time will tell if sunk costs turn tides and recuperate investments.
In sum, common investor fallacies create rational gaps allowing for overconfidence, confirmation bias, an illusion of control, recency bias, and hindsight bias (Chen, 2019). These biases enter our decision-making process at the expense of proper due diligence and adherence to a predetermined investment thesis.
So what is this all about? Why should we care?
Let us now take a step back and return to the basics of two critical economic theories: traditional and behavioral economics.
Financial advisors interweave the theoretical fabric of traditional economics and its rational assumptions with the observed reality of behavioral economics and its impact on the decision-making of both their investors and their investments.
You see, the thing is, the behavioral economics “factor” and its biases are inevitable. There is even growing research into and backing for the legitimacy of our intuitive analyses and gut reactions. Ultimately, however, investment decisions should be made from traditional economics backbones and their rational observations and assumptions of irrational behavior.
Figure 2: Economic Theory Comparison
Navigating the yin and yang of these two forces can help you identify and unlock opportunities for your portfolio that are in line with our investment thesis and your financial goals and preferences.
When GameStop’s (GME) stock price saw a 17x multiple in a mere 15 days or as Tesla’s (TSLA) stock surged 685% in 2020, it is crucial to stop and pause to gather information and conduct due diligence.
Review a company’s technicals and review the market’s fundamentals to assess the real opportunity versus the headline hype. What are traditional metrics and benchmarks that we can return to? What “human” factors or uncontrollable forces should we account for? How much is stock performance supported by brand loyalty, competitive advantage, or proven executive leadership?
Originally published March 15, 2021, in partnership with Fagan Associates Inc.
© 2021 Sara J. Wells
References
Bogan, D. V. (2019, February). Behavioral Economics vs. Traditional Economics: What is the difference? Retrieved from Hartford Funds: https://www.hartfordfunds.com/investor-insight/behavioral-economics-vs-traditional-economics.html
Chen, J. (2019, May 21). Hot Hand. Retrieved from Investopedia: https://www.investopedia.com/terms/h/hot-hand.asp
Corporate Finance Institute®. (2021, March 12). What is Hot Hand? Retrieved from Corporate Finance Institute®: https://corporatefinanceinstitute.com/
Tuovila, A. (2021, February 25). Sunk Cost. Retrieved from Investopedia: https://www.investopedia.com/terms/s/sunkcost.asp
