Keeping Our Heads

Jonathan Clements

WHAT WORRIES ME? It isn’t the stock market, but rather stock market investors.

Despite all the hand-wringing, this doesn’t strike me as an especially dangerous time to own stocks. Corporate earnings are rapidly recovering from last year’s economic shutdown—not exactly a scenario where you’d expect a big stock market decline. Meanwhile, bonds and cash investments are offering scant competition for investors’ dollars, which is another reason to be bullish on stocks.

But even if the overall market appears no riskier than usual, there’s a danger that we’ll put ourselves in financial peril—by falling into one of these three behavioral finance traps.

1. Overconfidence. As financial markets rise, so too does our confidence. There’s nothing like making great gobs of money to make folks think they’re smarter than they really are. What if their results are mediocre compared to the market averages? Investors are often blissfully unaware—and simply assume they’re beating the market.

One indicator of our collective overconfidence: Average daily stock market trading volume in 2020 and 2021 has been running 63% above 2019’s level. When investors trade, it’s typically a sign they feel they know what they’re doing. But all that trading is costly. Sure, we might not pay a commission when we buy and sell stocks. But we still lose money to the bid-ask spread, the slight difference between the price at which we can currently purchase a stock and the lower price at which we can sell.

Even more worrisome, overconfidence can lead us to make big, undiversified investment bets. For some, those big bets will pay off handsomely—but, for most, the result will be market-lagging returns. How can I be so sure? Almost every year, the stock market averages are skewed higher by a minority of stocks that post spectacular gains, leaving most stocks with market-lagging performance. If we aren’t lucky enough to own the big winners, we’re destined for subpar returns. This is a reason to own total market index funds, which ensure we own all stocks, including each year’s superstars.

2. House money effect. Overconfidence can lead us to make risky investment bets. Adding fuel to this fire: the house money effect. What’s that? Think of casino gamblers who get lucky early in the evening. They now feel like they’re ahead of the game and playing with the house’s money—and that can prompt them to make even bigger bets.

The same thing happens with investors. After the spectacular U.S. stock returns of the past decade, many investors are financially far ahead of where they expected to be. The danger: They figure they can afford to take yet more risk by, say, dabbling in individual stocks or taking a flier on cryptocurrencies—and those bets could come back to haunt them.

Over the past year, we’ve seen a variation on the house money effect, and I suspect it’s especially prevalent among newbie investors. Their surprise windfall came not from the market, but in the form of stimulus checks and lower spending during the pandemic. They’ve taken this “found” money and started dabbling in meme stocks, dogecoin, Tesla and goodness knows what else.

Two decades ago, I fell prey to a similar phenomenon. In the late 1990s, I received $8,000 when my father cashed in a life insurance policy on which I was a co-beneficiary. Emboldened by both this windfall and that era’s euphoria, I strayed from my usual indexing strategy and used that $8,000 to buy four individual stocks. One company got taken over at a handsome premium. Two performed okay. And one plunged almost overnight—and I bailed out when the stock was down some 80% from my purchase price and on its way to zero. I haven’t owned an individual stock since, except a few hundred shares of my last two employers.

3. Extrapolating returns. Last year, many investors crowded into some of the market’s highest fliers, including Peloton Interactive, Netflix and Tesla, only to see these stocks struggle in 2021. In many cases, it seems folks were buying these stocks simply because they’d gone up and they naively assumed those gains would continue.

But these days, investors don’t just chase performance. They also flock to the internet to loudly proclaim their devotion and get encouragement from others, all this leading to dangerous herding behavior. For instance, earlier this year, the higher cryptocurrencies climbed, the more virulent supporters became—only to fall almost silent during the recent rout. This phenomenon even infects staid value investors. These folks have been notably quiet in recent years. But with value outperforming growth in 2021, those whose portfolios have a value tilt are more likely to mention it in public.

Some degree of investment conviction is a good thing. It helps us to stick with our portfolio when markets turn rough. But we shouldn’t let conviction morph into blind loyalty. Today, folks will defend their favorite investments with a fervor usually reserved for a local sports team or a preferred political party. But no undiversified investment deserves that sort of undying love.

As I mentioned in an article earlier this year, thanks to the market’s efficiency, there’s no reason to think professional investors will be any more successful than amateurs at picking winners. Instead, I believe the hallmark of professional investors—as well as prudent amateurs—is that they think more about risk.

We’ve seen the S&P 500 climb 16% this year, ignoring dividends. But we’ve also seen some much-ballyhooed investments badly stumble, with Tesla down 27% from its high, bitcoin off 48% and ARK Innovation ETF down 21%. The lesson: The market giveth—but, if we behave foolishly, it’s all too easy to see those gains taken away.

Jonathan Clements is the founder and editor of HumbleDollar. Follow him on Twitter @ClementsMoney and on Facebook, and check out his earlier articles.

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