Have you ever seen a dog chasing a Frisbee? The dog locks onto the spinning disc with singular focus and launches into a dead sprint. Well-trained dogs run to where the Frisbee will land, make slight adjustments along the way, and arrive in time to make the catch right before it hits the ground.
A lot of factors determine where the Frisbee is actually going to touch down: how hard it was thrown, wind speed, temperature, altitude, the number of bite marks from previous canine encounters, etc. Yet, the dog doesn't calculate all of those factors when launching his pursuit. He picks a line and goes; ears back, tail up, hell bent for leather to get the Frisbee.
In much the same way, we humans also tend to do better when we take simpler approaches to tasks and obstacles in our lives. When provided with pictures rather than complex instructions, people take the appropriate doses of medicine more often. We often provide more creative solutions at work when instructions are broad and simple rather than specific and detailed. It’s our psychological tendency to try to cram more “reasoning” into a decision-making model than is necessary. Look at athletes. They go through bizarre rituals of licking fingers, adjusting sensitive areas, kicking dirt, wearing specific wristbands, and the like because something positive happened one time and they don’t want to change the routine that they thought brought them success. Rather than identifying hard work, natural talent, and some luck, they create other factors to explain success.
We do the same when we invest. Let’s look at some of the biases which creep into our decision-making processes:
Familiarity bias. We assume that just because we’ve heard of a company name before, it must be good. Think of cameras. What name still comes to mind? Kodak? Bankrupt.
Tyranny of choice. When presented with lots of choices, our brains freeze, and we can’t make a decision. Rather than spend the time to compute the utility of each one, we tend to pick the first option. This happens in a wide range of investing scenarios, from choosing 401(k) investments to determining what mutual fund to invest in. Rather than create simple screens or rules of thumb, we wind up not investing at all.
The Dunning-Kruger effect. This phenomenon is a result of our inability to recognize when we’re not good at something. Actively managed mutual funds—those managed by professionals—underperformed their benchmarks 67.72 percent of the time over the past five years; yet, we somehow think that as armchair quarterback investors, we can do better.
Endowment effect. This psychological bias makes us view something that we own as more valuable simply because we own it. If you’ve ever had a successful investment before, then you’re more likely to buy it again later, even if the fundamentals of the company have changed dramatically.
These are but a few of the myriad biases that cause us to complicate our investments.
Still, even in a world full of distractions and biases, the dog chasing the Frisbee usually winds up close enough to the landing spot to make a catch. We can do the same thing when we consider investing. Here are a few suggestions:
Don’t overcomplicate investment choices. Stick to index funds. Diversify with indices in different sectors. Don’t invest in complicated strategies you don’t understand and that could expose you to unexpected risk.
Narrow the field. Have a ton of choices in your 401(k) and can’t decide which ones to invest in? Pick a couple of low fee index funds, set up automatic investments, and only look at it annually.
Trade minimally. One of the biggest contributors to a portfolio’s loss over time is overtrading. We tend to sell low and buy high while commissions and fees eat up our capital.
Keep your eye on the target. You have investment goals, right? Keep those in mind. Don’t chase day-to-day or hour-to-hour returns. We often remember the guy told us about the 1,034 percent return he got in one day investing in pig snout futures, but fail to recognize that he fell victim to recency bias, as he didn’t tell us about losing 97 percent of his nest egg in similar wild schemes before that one lucky day.
Focus and consistency matter in long-term investing. Don’t unnecessarily overcomplicate your investing strategies, lest you wind up nowhere near where the Frisbee has been thrown.
Jason Hull is a candidate for the CFP(R) Board's certification, is a Series 65 securities license holder, and owns Hull Financial Planning.