We continue with the series on psychological pitfalls you need to be wary of when investing.
For this round, we look at fallacies, defined as “invalid or faulty reasoning” when constructing an argument or arriving at a conclusion.
Fallacies are common occurrences and there are many present in the investing realm.
In case you missed the first 12 pitfalls, you can catch them in the links below.
Part 1 – click HERE
Part 2 – click HERE
Part 3 – click HERE
Part 4 – click HERE
Let us look at three fallacies that could trip up your investment process.
Fallacy of accident
This fallacy describes a situation where an argument may sound logically valid but produces ridiculous conclusions.
As an example, an investor may have noted that several companies that committed fraud all had names starting with the letter “S”.
The next time he encounters a company with a name starting with “S” that has suspended trading, he automatically assumes that it had committed fraud.
This scenario leads to false conclusions because the underlying logic behind the conclusion is not sound.
Gambler’s Fallacy
This fallacy involves a mistaken belief that if something happens more frequently than normal during a certain period, then it should occur less frequently in the future.
A good example is a gambler that is betting on red or black at the roulette wheel.
If black comes up eight times in a row, the gambler may believe that it cannot possibly appear for a ninth consecutive time.
This conclusion is arrived at despite each roulette wheel spin being an independent event that is not tied to the results of previous spins.
When applied to investing, a stock may rise for five consecutive days, after which an investor would conclude that it had already “risen too much” and is therefore poised for a fall.
There could be a myriad of reasons for the rise in the stock price.
If these conditions persist, then there is no reason why stock prices cannot continue to head higher.
Investors who are afflicted by the Gambler’s Fallacy tend to assume that something should happen less frequently just because it had occurred more frequently in the past.
The fallacy may extend to the earnings and revenue growth of a company.
If the investor has witnessed many consecutive quarters of growth in revenue and earnings, he may develop a feeling that this “run” is coming to an end soon, without any objective basis to validate his logic.
Psychologist’s Fallacy
The psychologist’s fallacy arises when a person’s own subjective experiences interfere with the logical conclusion of a certain topic or decision.
An example can be illustrated as follows – a diner in a restaurant feels that the food and service are good.
But this may occur because a particularly polite waiter is serving him or his taste buds are different from other diners.
The reality is that reviews for the restaurant may be generally poor or negative, but this diner’s own personal (subjective) experience led him to conclude that the restaurant was good.
Investors should not let personal experience cloud their judgement of the investment merits of a company.
Clear examples would be cases where an investor uses a product or service of a listed company and feels satisfied with it, while other customers may have had negative experiences.
The investor may then act on his personal beliefs and purchase the company’s shares without first verifying if his conclusions on the company’s products or services are objective and rational.
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Disclosure: Royston Yang does not own any of the companies mentioned.
