July 8, 2021

Beware: Common Fallacies Lurking Nearby

Dennis Fagan
Aaron Fagan

Originally, we set out to address the most common investor fallacies that we work to protect you from as your fiduciary financial advisor. We quickly found ourselves pulling and pushing at the yin and yang of traditional (rational) economics and behavioral economics.

Let’s begin with the low hanging and tempting fruits of fallacy – hot hand, gambler’s, and sunk cost to name a few. These common investor mistakes may ring a familiar sound as their impacts resonate across behaviors and contexts.

Think of Lebron James, whose hot hands are on a 1,000+ game streak (regular season only) of scoring 10 points or more per game. Is it tempting to bet his streak will continue? In his next game? Season?

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Pivot quickly to 1913 Las Vegas at the Monte Carlo Casino, where gamblers lost millions continuing to bet on red while the wheel’s ball continued to land on black 26 times in a row.

Or recall the failed 2019 WeWork IPO when the company’s valuation fell from $47 billion to less than $10 billion almost overnight… despite the $18.5 billion that Softbank and its holdings had sunk into the company?

The hot hand and gambler’s fallacies represent two different sides of the same coin, straddling each side of an inaccurate understanding of probability. Hot hands overvalues the momentum of a hot streak while gambler’s undervalues the independence of statistical probabilities.

A bet on James’ hot hands streak should consider if a game is home or away, who the component is, or a change in team dynamics as these additional factors influence his performance. In Monte Carlo, gamblers incorrectly assumed that the changes of landing on red increased as the black streak lengthened – they did not adequately consider statistical independence.

These inaccurate assessments and their assumptions can be extended to an individual stock, sector, or fund manager’s performance. Both fallacies consider past performance as indicative of future results, whether it be a continuation or reversal of the precedent.

Pause here and make note. Past performance is no guarantee of future results.

Our third familiar fallacy is sunk-cost. This tune takes advantage of the phrase “no pain, no gain.” In playing on our brain’s perception of the pain of loss twice as great as the reward of gain, we can be tempted to continue to sink capital in hopes of turning the tides and recuperating costs.

Return to Softbank’s dilemma as WeWork lost 89% of its value between September 2019 and September 2020. To reinvest in hopes of recovery or to stop before digging the hole deeper?

They chose to double down, replacing then-CEO and co-founder Adam Neuman with tenured real estate executive, Sandeep Lakhmi Mathrani as one example of continued investment. While the strategic leadership change is meant to be a positive market signal, their business model remains challenged by a post-COVID remote work reality. Time will tell if sunk costs will turn tides and recuperate investments.

In sum, common investor fallacies create rational gaps allowing for overconfidence, confirmation bias, illusion of control, recency bias, and hindsight bias (Chen, 2019). These biases enter our decision-making process at the expense of proper due diligence and adherence to a predetermined investment thesis.

So what is this all about? Why should we care?

Let us now take a step back and return to the basics of two critical economic theories: traditional and behavioral economics. Financial advisors interweave the fabrics of traditional economics and its rational assumptions with the observed reality of behavioral economics and its impact on decision making – of both their investors and their investments.

You see, the thing is, the behavioral economics “factor” and its biases are inevitable. There is even a growing research into and backing for the legitimacy of our intuitive analyses and gut reactions. However, financial management and investment decisions should be made from the backbones of traditional economics and its rational observations and assumptions.

As your financial advisors, we help navigate the yin and yang of these two forces to identify and unlock opportunities for your portfolio that are in line with our investment thesis and your financials goals and preferences.

When GameStop’s (GME) stock price saw a 17x multiple in a mere 15 days or as Tesla’s (TSLA) stock surges 685% in 2020, we stop and pause to gather information. We review a company’s technicals and review the market’s fundamentals to assess the real opportunity versus the headline hype.

What are traditional metrics and benchmarks that we can return to? What “human” factors or uncontrollable forces should we account for? How much is stock performance supported by brand loyalty, competitive advantage, or proven executive leadership?

Please note that all data is for general information purposes only and not meant as specific recommendations. The opinions of the authors are not a recommendation to buy or sell the stock, bond market or any security contained therein. Securities contain risks and fluctuations in principal will occur. Please research any investment thoroughly prior to committing money or consult with your financial advisor. Please note that Fagan Associates, Inc. or related persons buy or sell for itself securities that it also recommends to clients. Consult with your financial advisor prior to making any changes to your portfolio. To contact Fagan Associates, Please call 518-279-1044.

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