Read this if you’re feeling left out
Earlier this year, a seemingly outrageous spike in the value of GameStop stock (NYSE:GME) caught everyone’s attention. There are several interesting factors that contributed to its sensational rise in popularity and subsequent market controversy, which have been covered extensively by popular news outlets. In today’s blog, we won’t go into the historical details, but we will instead discuss how the science of human psychology can help us make sense of why these wildly speculative retail investing events happen, and why you are wise to ignore them and stick to your investing plan.
If you’re a Mana client, you’ve probably heard us broadly advise against this, or advise you to treat these kinds of transactions like a casino bet (e.g., minimize them, and count them as money spent -- not a strategic investment). Nevertheless, we recognize that many of our readers might be feeling left out from all of the “fun” of this style of trading. After all, it seems like lots of people are making it BIG lately. And actually, that’s true...some people did make a lot of money this month. Perhaps you’ve visited Reddit’s wallstreetbets forum yourself, or heard through the grapevine about big winners during the GameStop peak. Perhaps some of your day trader friends have become emboldened to share their massive gains, hot tips, or rosy predictions about the future of a particular stock. Well, spoiler alert: this post is not going to uncover any industry secrets, or even motivate you to participate. Instead, we’re going to discuss the reality of the situation, which can be characterized by a number of logical fallacies and cognitive biases.
What do we mean by ” fallacies” and “biases”? A logical fallacy is essentially an error in logical reasoning, stemming from a flawed argument. A cognitive bias is an error in reasoning that occurs due to problems with cognitive processing (e.g., errors in memory, attention, attribution, or other sensory and mental blunders). Both of these devices lead us to think and act irrationally, resulting in poor judgement and decision making. They are studied extensively in both psychology and behavioral economics, because of their impact on day to day life and financial wellbeing. Below, we’ll ask and answer a couple of big questions about what’s going on in the news, in the context of the fallacies and biases associated with active trading and investing, as well as their connection with disordered risky behavior, which is often studied in the context of gambling and addiction.
What’s interesting about the behavior we’re seeing in the retail investment space?
The answer to this question, we really need to look at the barrage of trading information and investment news that people are experiencing right now. In particular, what we’re seeing and hearing on a daily basis is a lot of news about people making a lot of money quickly. Right away, there is an easy parallel to draw between the constant stream of positive investment stories on our newsfeeds and the flashing lights and jackpot noises you hear in casinos. Retail investing looks very similar to gambling in normal times, and it becomes extraordinarily similar in these sensational times when certain stocks peak unexpectedly in a bull market. One of the cognitive biases this is taking advantage of is the Availability heuristic, which is a mental shortcut that causes us to rely on “the information available”, or the most recent/immediate examples that come to mind when we evaluate a specific situation or topic. It’s the reason that many people fear flying in airplanes over driving in cars. Even though the statistical likelihood of getting into a car accident is far greater, people often hold onto vivid memories of tragic news stories about plane crashes, which makes them seem more frequent or likely to happen than they are. To illustrate this further, you can imagine a free association game where you are asked about the first thing that comes to mind when you hear the word “stocks”. If you’re reading this blog post in February 2021, it’s probably GameStop or Tesla, since there has been so much news coverage about them lately. Additionally, the specific news that you are hearing or reading about GameStop is probably biased towards the large gains that people have made from these investments.
What makes the availability heuristic particularly insidious in this context is another parallel between overconfident retail investors and gamblers who think they’re going to win big. Both groups are making a type of Base Rate fallacy, which is a fallacy that describes when people overweight the magnitude or likelihood of individual events or specific information, while ignoring the underlying base rate for that information or event. This can lead to people expecting unlikely positive events to happen more often than they do, because they ignore the true ratio of positive to negative events. There are well-known phrases in both gambling and investing that accurately describe the state of the world. In the world of gambling, it’s “the house always wins”, meaning that in the overwhelming majority of cases, the gambler is going to ultimately lose more money than they win. It’s how the system works-- otherwise the casinos would quickly be out of business. In investing, the phrase is “you can’t beat the market”, and it’s true about as often as “the house always wins”-- the vast majority of retail investors can’t outperform general market returns. In fact, the odds of doing a good job are incredibly slim: about 90% of actively managed investment funds fail to beat the market each year. Despite this stark reality, we tend to see spikes in “new investment advice” and active trading strategies after stock market anomalies like the GameStop event. It’s important to remember that most of these tips are just as superstitious as blowing on the dice in a game of craps.
What about people who are already actively invested? What are some of the cognitive pitfalls or dangers that they face?
Once again, there are some strong parallels between the risky decision making behaviors associated with ongoing active trading and gambling. Individuals who are investing in single securities, who are day trading on short time horizons, are often trying to glean a meaningful signal from random noise in the market. They are in essence, committing a version of the Gambler’s fallacy, which is sometimes called the Monte Carlo fallacy. This fallacy is a belief that if an event occurs more or less frequently than normal during a specific timeframe, that it will subsequently be more or less likely to occur in the future, when the probability of these events is not based on their past occurrence frequencies. In both gambling and the stock market, it is critical to remember that future events (e.g., the rise and fall of individual stock values) are not causally, temporally, or 1:1 linked to past events (although, events in the market are sometimes a result of geopolitical or business news, they are critically not influenced by past statistical trends or forecasts for individual stocks). Even when news or current events do drive changes in stock prices, it is impossible to predict the short time horizon that peaks and valleys will occur with any meaningful level of precision. At best, people are making “educated”, but ultimately lucky guesses. Still, many people who lose money on short positions or purchases of expensive stocks will continue to believe that their personal streak of negative events is indicative of some future positive event. Just like gambling, it is possible - and even likely - that active trading will result in consistent and sustained loss, with no causal upside. This is one of the reasons that we consider longer time horizons for whole market predictions at Mana; anything more granular or specific would be an unnecessarily risky or uninformed position.
Another, sometimes tragic pitfall of active investing is called loss-chasing. This is related to the Sunk Cost fallacy, and happens when instead of accepting a loss, a person invests or gambles more money in an attempt to recover from that loss. To explain this more simply, it is why gamblers who have lost $500 on a bad bet may make an even bigger bet, say $1000, to try to get out of the hole that the first bet put them in. The sunk cost makes them believe that their luck can change and the next bet is going to be a big winner that makes up for previous losses, while having an inappropriately optimistic assessment of their ability to win big this time. It also leads people to overspend, over-eat, or even make risky decisions in the outdoors (e.g., “we’ve already hiked so far, we might as well continue up this dangerous, icy pitch to the summit…”). In all of these cases, walking away with the money you have left, or turning back to avoid slipping and falling would be the more logical decisions to make - regardless of how incomplete they might feel. Online brokerages are making it exceptionally easy for the average trader to expose themselves to this fallacy, and while we’re not covering the ethical or regulatory side of this phenomenon, it has been well documented in the media this year. Famous behavioral economist, George Loewenstein, has performed extensive research about the idea of “risk as feelings”, which demonstrates why these emotionally charged risky situations lead to illogical decisions. A particularly interesting and concerning finding from this line of research is that neither experiencing a personal near-miss, nor hearing about someone else’s devastating loss, is likely to make you a more logical evaluator or rational decision-maker. Humans are unfortunately incredibly resistant to rational judgement (see our past blog post for more about this), especially in the emotionally charged world of finance, and loss chasing is one of the greatest concerns for active investors.
Mana FLD’s “hot investment tips”
Our biggest hot tip is: we don’t give out hot tips! There is plenty of room for creativity in the world of investing, but most of this should revolve around individual goals, circumstances, and weighing personal risk tolerance against sound options. At Mana, we construct and manage portfolios with specific, useful time-horizons that are matched with client objectives and tax considerations. For our Financial Life Design clients, we make individualized recommendations about adequately diversified strategies, and even encourage divestment from company stocks after IPO. Putting all of your financial eggs in one basket is a dangerous and unsupported decision, as we’ve detailed above, and we won’t encourage or advise active trading as a client investment strategy. But hey, we don’t want to ruin all of the “fun”. If you want to explore the world of retail investing, we advise that you establish firm guardrails (e.g., use a small, set dollar amount of cash on hand - not borrowed money) to play with. Acknowledge it as a fun experience, and not a revenue stream. Stay aware of the pitfalls and dangers associated with this style of investing, and just like the casino, know when to “walk away”. In all cases, we highly recommend working with a fiduciary advisor like a CFP® to discuss these choices, and working with an investment manager to build a viable strategy to grow your wealth. There’s no predicting or beating the market, but a sound, professional investment strategy is a critical element of personal finance.
Madison Elliott is a Cognitive Science PhD Candidate at The University of British Columbia in Vancouver, BC, Canada. Madison leads data engineering and usability at Mana Financial Life Design (FLD). Mana FLD provides comprehensive financial planning and investment management services to help clients grow and protect their wealth throughout life’s journey. Mana FLD specializes in advising ambitious professionals who seek financial knowledge and want to implement creative budgeting, savings, proactive planning and powerful investment strategies. Madison brings her combined background in cognitive science, computer science and clinical psychology with her professional UX design and engineering experience to optimize workflows at Mana FLD and improve people’s lives.