A Dangerous Idea

My colleague and fellow blogger Bob Seawright recently asked several of us in the business to contribute a “dangerous idea” for a piece over on his blog Above the Market. My contribution is below, but you should head over and read the entire piece.

“I was right” may be the most dangerous thought that presents itself to an investor. Maybe you have a friend who bought Apple under $50. Maybe a friend “foresaw” the 2008 financial crisis and sold most of his stocks in late 2007. Maybe it was something as small as dipping into high yield bonds when spreads were at historic highs or shortening the average maturity of his bond portfolio earlier this year.

Whatever the circumstances, your friend now sees that he did something right. And therein lies the danger. When we’re “right” about a one-time investment decision, all of our behavioral biases kick in. Suddenly, we’re geniuses! Certainly it wasn’t luck that had us buy into Apple early or bail out of the markets at a fortuitous moment! It was purely our skill, and not a random but fortuitous series of events that led to this outcome. Our self-serving bias tells us that of course we could see the bear market coming and of course we knew that Apple would increase 1000% and of course bond yields were headed up. We rebuild our memory of the event in the most flattering light possible.

In turn, this makes us overconfident. We take credit for being right, and assume that we’ll be right again! We’ll find the next Apple before a historic run, we’ll dodge bear markets with grace, we’ll always take the right risks at the right time, because we’ve done it before!

If we cannot recognize our limitations, we’ll fail. Our portfolios will become too concentrated, we’ll rely too much on timing the market and believe too strongly in our ability to execute winning investment strategies. We must take a more objective view of our abilities, and we must rely on a well drafted investment policy to reign in our otherwise misguided minds.

Keep reading The Carnival of Dangerous Ideas at Above the Market.

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