One goal. A better life.
“This is a masterpiece.”
—Morgan Housel, author, Psychology of Money
“Discover the extraordinary within yourself.”
—Manish Chokhani, Director, Enam Possess
The Internet is full of sources claiming that “almost everything you thought about investing is wrong.” However, far fewer are willing to help you become a better investor by revealing that “much of what you think you know about yourself is wrong.” In this series of posts about the psychology of investing, I will take you on the journey of the biggest psychological flaws that plague us and cause us to make stupid mistakes when investing. This series is part of a joint investor education initiative between Safal Niveshak and DSP Mutual Fund.
There is a story about a turkey that Nassim Taleb shared The Black Swan.
Every morning for a thousand days the butcher feeds the turkey food he loves. Over time, the turkey grows bigger and feels happy.
From the turkey’s perspective, the butcher is its best friend. Why wouldn’t that be the case? The turkey has 1,000 days of proof that this man is caring for him. It feels completely safe. So when day 1001 arrives, the turkey has nothing to worry about. In fact, it is absolutely certain that it will be another great day.
The 1,001st day is Thanksgiving. The turkey is slaughtered.
The turkey’s fault was not a lack of intelligence. It was simply assumed that because things had gone well for a long time, they would continue to go well. This is the deeper pitfall that Taleb warns about, namely the danger of letting past patterns fool us into believing that they will continue into the future.
A close cousin of this trap appears as the Hot-Hand Fallacywhich is the belief that a recent streak indicates that more success is likely ahead. Where Turkey relied on stability, investors often rely on momentum. And while these mistakes may look different at first glance, they arise from our brain’s habit of converting yesterday’s pattern into tomorrow’s expectation.
That’s where the problems usually start.
The first time the Hot-Hand Fallacy was described was in 1985, in a study by Thomas Gilovich, Amos Tversky and Robert Vallone. They studied basketball data and challenged the popular belief that a player who has just scored is somehow “in the zone” and therefore likely to score again. Their analysis suggested that what fans celebrated as a mysterious wave of confidence or rhythm was, in most cases, simply randomness that was misunderstood.
Now the human mind doesn’t like randomness. We prefer patterns because patterns make the world feel predictable. And so, even if numbers don’t reveal such ‘momentum’, the mind insists on creating it.
This tendency, that success must continue simply because it has already occurred, is the essence of the Hot-Hand Fallacy. And while it may seem like an amusing quirk of sports psychology, the real-world playground has far more ramifications. We call it the stock market.
Consider a friend who buys a stock just because it has doubled in a short time. When you ask him why he thought the rise would continue, he points to the map as if it contained divine instructions. This is the investor’s version of passing the ball to the “hot” player, or believing that an upward trend has its own internal momentum.
The truth, which is simpler and less reassuring, is that a price moves because people trade at that price. Nothing in that movement guarantees what tomorrow will bring. But our brains evolved at a time when patterns were linked to survival. If berries were found twice under a particular tree, it was logical to assume that the area was fertile. Unfortunately, markets breed illusions and not berries.
Now this alluring nature of stripes is appearing in the markets in many forms.
A fund manager who beat the market for two years is believed by investors to have cracked a secret code.
An investor who correctly anticipates some profit outcomes begins to imagine that he has gained a deeper insight.
An industry that is steadily rising is met with ready-made explanations, often recited with great confidence.
In both cases, a brief burst of success becomes a story of genius and inevitability. But what feels like a pattern is often just a statistical accident. Tversky, who has studied cognitive distortions all his life, once noted that people are “remarkably bad” at distinguishing between chance and causality. The stock market adds an emotional twist to this weakness. Since this is about money, randomness starts to look like personal skill.
After a few winning decisions, even sensible investors begin to feel a faint glow of invincibility. The inner voice says, “You got it,” and suddenly the streak becomes part of one’s identity. The investor who has made a series of correct decisions feels that the universe is finally rewarding him for his intelligence. This is precisely the moment when judgment begins to waver.
Every bull market contains a catalog of stocks or mutual funds that seem unstoppable. They become the heroes of the dinner conversations and for a brief moment they seem immune to gravity. Then, as always, gravity returns. History is littered with companies whose ‘invincible’ streaks abruptly broke. In retrospect the fall always seems obvious, never during the rise.
A better way to approach streaks is to treat them not as predictions, but as clues to deeper investigation. When a stock has risen, the important question is not whether the rise will continue, but what underlying conditions justify the move. Are the fundamentals improving, or is this just a matter of enthusiasm chasing itself? Is the recent performance sustainable or temporary? Most importantly, if you had no information about the stock’s recent price action, would you still be interested in owning it? That one question takes away the hypnotic effect of the card and forces the mind back to reality.
Buffett summarized this wisdom when he wrote:
“What the wise do in the beginning, the fools do in the end.”
Now the question: How can you avoid the Hot-Hand Fallacy or minimize its impact on your financial life?
Well, like all prejudices and misconceptions, it requires no special intelligence, just a willingness to separate emotion from evidence.
It involves reminding yourself that markets are inherently unstable and therefore past success comes with no commitment to the future.
It involves resisting the pleasure of believing that our recent successes reflect our skills and not a mix of randomness and luck.
Above all, it takes humility to recognize that a series of events can end with the same abruptness with which they began.
A winning streak is a wonderful thing to experience. Enjoy it.
Just don’t count on it. Because the butcher will come at any moment, and he doesn’t care about the story you tell yourself.
Disclaimer: This article was published as part of a joint investor education initiative between Safal Niveshak and DSP Mutual Fund. All mutual fund investors must go through a one-time KYC (Know Your Customer) process. Investors may only deal with registered investment funds (“RMF”). For more information on KYC, RMF and the procedure for filing/redressal of any complaints, please visit dspim.com/IEID. Investments in mutual funds are subject to market risks; read all fund-related documents carefully.
Two books. One goal. A better life.
“This is a masterpiece.”
—Morgan Housel, author, Psychology of Money
“Discover the extraordinary within yourself.”
—Manish Chokhani, Director, Enam Possess
#Psychology #Investing #Dangerous #Illusion #Hot #Hand #Safal #Niveshak