Our brains evolved to function in environments far different from the ones we live in today. This can cause us to respond to our environment in ways that, while they were useful on the savannah when we were hunting elephants, can be very toxic to the health of our investment portfolios. The dangers of these unexamined ways of thinking are particularly dangerous for people investing for retirement who rarely have the training or depth of experience characteristic of professionals who trade stocks for a living.
In my previous article we examined one of these toxic thought patterns that threaten those saving for retirement, the one psychologists label "confirmation bias." Now we are going to look at another built-in tendency of our brains that goes a long way to explaining why it is so easy to fall prey to confirmation bias: our tendency to see patterns where they don't exist.
Psychologists give this tendency the fancy name pareidolia.
The most well-known examples of it occurs when people see the face of Jesus in a piece of toast or on the top of their pizza. This actually happens quite frequently.
We are prone to seeing pattern where it doesn't exist because through much of our evolutionary history, our ancestors were a lot safer interpreting a set of wavy stripes seen off in the distance as a tiger than they were dismissing it as the shadow of branches. If they were wrong and the stripes were just branches, they only burned up some calories scampering off as fast as they could run. If they were right and it was a tiger, they did not get eaten and survived to become our ancestors.
Unfortunately for modern investors our brains' tendency to make order out of chaos does not just affect us when we see inspiring images while staring at our lunch. It also manifests as a strong tendency to arrange unrelated tidbits of information into stories, which, once assembled, dominate our understanding in ways that can seriously distort our ability to analyze information objectively.
Stories Have Characteristics Which Make Us Feel Good
Stories, by bringing order out of chaos, make us feel safe. The most satisfying stories have a predictable shape, whether they appear in your favorite sit-com, an eleven volume fantasy epic, or the tale your teenager tells you about where he was the night he didn't come home from the prom.
A satisfying story has a beginning and an end. It features some kind of conflict. That conflict may take place between a hero and a villain or between a hero and an impersonal force such as a natural disaster. Most people overwhelmingly prefer happy endings, and the most successful stories that make it into books or movies make sure to provide them.
The stories our brains like best leave out everything that doesn't fit into the pleasing shape of the story. In a good story, if the heroine has a problem, it will be solved in a way that makes us feel good. In a mystery, the identity of the murderer will be revealed. All extraneous facts about the hero or the murder are left out of the story. Every novelist is aware of Chekhov's famous saying, "If you say in the first chapter that there is a rifle hanging on the wall, in the second or third chapter it absolutely must go off. If it's not going to be fired, it shouldn't be hanging there." And that is how they construct their stories.
There is nothing wrong with enjoying a story, when we know it is a story. No one is going to suggest you shouldn't enjoy another episode of James Bond. But our attraction to stories becomes toxic when our reasons for buying, holding and selling stocks in is overly influenced by the stories we and others tell about those stocks. Real life--and stock investment--is full of guns hanging on the mantelpiece that do not shoot. Products are announced that go nowhere. Executives, unlike heroes, run into problems they can't solve and get fired. And unlike the case in stories, sometimes we don't find out the identity of the murderer until it has killed our stock.
Why Turning Information Into Story Harms Your Investing
The truly toxic feature of stories is that for your brain to find a story satisfying, you have to screen out and ignore the many discordant facts that don't fit into an easily understood, easily remembered pattern. But once you have reduced the reasons you believe in a stock to a simple story, you can maintain that story only by ignoring the many, complicated factors that don't fit the story--factors you need to understand to invest safely. That is why it is almost always the case that the simpler and more appealing the story is behind a stock, or investing strategy, the more likely it is to fail.
Investing is hard and there are no shortcuts to life-long wealth. Some people are lucky, and buy the right stocks at the right time using very simplistic strategies. I've met some myself, I'm sure you have too. They buy stocks that seem to be going up when they are actually going up and sell ones that are seem to be going down before they plunge. They buy a company with a brand new, can't fail product, and it doesn't fail. They buy the S&P 500 Index Fund in 1981 and hold it forever. But these investors are outliers. They are lucky the way people who buy lottery tickets are lucky. You are not likely to get rich or even end up with a satisfying retirement portfolio by following the simple strategies they followed, even though in retrospect, with a lot of pesky details omitted, they make for some very good stories.
The investors who can teach you something are those who base their investing decisions on a great deal of sometimes-conflicting information and who resist the temptation to simplify it by turning it into story. They look at all facets of a business, the financial statements, the histories of the executives running the business, the competitive environment within which the business works, the technology the company depends on, the demographics of the company's customer base, and a host of such factors. They will find that some of these factors make the stock appealing. Others will make them pause, as they point to potential problems. The effective investor retains the ability to hold these many factors in mind, to stay aware as conditions change, and to evaluate the impact of those changing conditions on the good and bad factors they've identified in their stock. They resist simplifying the many pieces of information they have about their stock into a pleasing romance, a soon-to-be solved mystery, or a three hankie tragedy
Meanwhile, the not-so-successful investors are often those who invest entirely on story. They find one simple pattern in the myriad of facts surrounding any investment and having seen the face of Jesus, ignore the fact that it appeared on a piece of toast.
Fortunately there are some things you can keep in mind that will help you avoid being bedazzled by a likely story.
Heroes and Bad Guys Don't Belong in Your Portfolio
If you are invested in a stock whose results aren't what you had expected, especially if it has a large amount of stock held short, resist the tendency to believe that the reason people are betting against the stock is because they are the villain and your stock a hero, poised in a battle for Truth, Justice, and the American Way.
For every sale of stock there is someone buying and someone selling, and each party in the transaction has a reason for doing what they are doing that they believe will allow them to make a profit. So open your mind to the possibility there are good reasons why people as bright as you are-or brighter-would bet against the stock, and that their reasons exist because there are many ways of assessing the value of the business you've invested in.
Owners of failing companies like MannKind (NASDAQ:MNKD) may take great comfort in the belief that their company's stock would be worth ten times its present value if it weren't for the machinations of fiendishly evil stock manipulators. But before you assume such claims are true, check out the company's recent SEC filing and read all the footnotes, the more boring the better, to rule out the possibility that it is you who were manipulated into buying a story stock whose lack of earnings, declining sales, and debt load, make it just as likely it will go bankrupt as that it will make you rich.
If you get involved with a stock where you are convinced that the price is being manipulated, which can happen with a very popular, small cap stock like MannKind, Fitbit (NYSE:FIT) or SolarCity (NASDAQ:SCTY) whose volatility makes it attractive to day traders, option traders, and high frequency trading programs, before you shout, "The game is rigged!" ask why you are putting your money into playing a game that seems to be rigged. It is safe to root for the forces of Good while watching Star Wars. But the forces of Good have a nasty way of having other things on their mind when you have invested more than you can afford to lose in a stock with a seductive story.
Investing is about business, and business is about making money and only about making money. So keep straight the difference between investing in a business and donating to a good cause. You are not helping the environment when you buy stock in a company like Tesla (NASDAQ:TSLA). You are merely buying stock from someone who doesn't think the company's current prospects justify its current price. You were not curing diabetes when you bought MannKind after the company's drug was approved. You were buying shares from other people who didn't see any point in holding on to them, which included most of the company's executives. You are not being loyal when you hold an outsize position in the corporation you worked for over 40 years. You are simply exposing yourself to a huge concentration risk, especially as you retire and no longer know what is really going on inside the company.
If you want to help people with diabetes, contribute to your local clinic that serves low income people who can't afford the medications they need. If you want to save the environment, ride your bike to work and buy solar panels. Companies don't get a cent when you buy their shares on the open market unless they are diluting the stock. Stories in which you save the world by investing in the "products of the future" are cheering fantasies that can be very hard on your wallet.
Don't Confuse the Pleasing Outcome So Beloved in Story with the Possible Outcomes Your Investment is Exposed to
Another point that can keep you from making serious investing mistakes is this: In stories, things get very dire for your hero before he figures a way out of the underground prison cell, leaps onto the top of a handy subway, and arrives at the central control station just in time to stop the bad guys from blowing up the Empire State Building. Repeated exposure to these kinds of stories has conditioned all of us to expect that the worse things get, the better our heroes will perform.
But stocks aren't heroes, and in the business world the worse things get, the more likely they are to get even worse. Companies under pressure may solve their problems, but they often do it in ways that harm stockholders. They may dilute their stock, take on crippling loads of debt, or get taken private in a deal that delivers the benefit of any turnaround to the billionaires who took over the company.
Only in stories can we count on getting the ending we hope for. In investing we don't. Just because you would like a given outcome to occur doesn't tilt the odds to make that outcome more likely. If your company has a wonderful product, as so many do, remind yourself that they don't make movies about the inventors who invented world-changing devices, but died penniless while some more savvy businessperson made millions from that invention, though there are plenty of inventors-and companies-that fit that description.
You would not have become rich investing in Radio Shack, even though you loved your Trash-80. And no one who lived through the disappointing launch of Apple's Lisa computer had any way of knowing they were invested in the company that was going to come out, decades later with the smartphone. After all, smartphone investors, until it was too late, threw their money at Blackberry (NYSE:BBY) and Nokia (NYSE:NOK).
The better you are able to embrace that the business environment is a messy, noisy place, where it is very hard to discern where the real tigers are and what is only the shadows of distant branches, the sounder your investing decisions will be. There are a hundred stories that could be told about any stock, any one of which-or none of which-could be true, the faster you realize this, the better off you will be as an investor.
So, that said, what are the likely stories you have fallen for over your investing career? How did they lure you in, and what woke you up from the pleasant dream of story to make the kind of decision that will ensure you have a safe retirement?
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.