The illusion of validity is a cognitive bias in which a person overestimates their ability to predict an outcome, particularly when the data “tell” a coherent story. Unsurprisingly, this is incredibly common in the investment world. There are so many compelling investment stories that seem reasonable — but when you apply common sense, suddenly, it starts to seem a little nonsensical.
Are you guilty of buying the story rather than the facts about an investment? Here are a few examples of areas where investors may be tempted to ignore the facts in favor of a compelling narrative.
[See: 10 Skills the Best Investors Have.]
“Exclusive” investments are notorious for this. In order to invest in a hedge fund, for example, you must be an accredited investor. And their air of exclusivity must mean they are better than what Joe Schmo investor has, right? Not so. The reason you must be an accredited investor is not because a hedge fund is inherently better than a low-cost ETF or fund — it’s because they are so risky that you are not allowed to invest in them unless you have enough liquid assets to recover from a loss. Add in high costs, and their tendency to underperform the broad indices, and hedge funds seem to be all talk and no walk.
There is a well-known mutual fund company which touts a similar “exclusivity” tag. In order to invest in the funds, your advisor has to “gain access” to these funds on their platform via a lengthy process. Even the data about the funds is not readily shared or transparent. From a story standpoint, marketing something as exclusive can add to the appeal. However, Vanguard research shows that significantly greater results come from sticking with an investment approach that minimizes costs, eliminates commissions, is diversified — and leaves the ego of exclusivity at the door.
Even more misleading are statements one often hears on financial media. There are more buyers than sellers. Or more sellers than buyers. Stock A is undersold, while Stock B is overbought. What in the world does all of this mean? Not that much really. There are two sides to every trade. For every person convinced that the latest news out of Company XYZ make it a must-buy, there is someone equally willing to sell their share.
The price of a security is simply a representation of the buyers and the sellers stacked up, at that particular moment in time. There is nothing particularly mysterious around that, yet in crafting the story for or against a particular investment, throwing about jargon like “undersold” can seem compelling.
Ignore extraneous details. A particular company or fund may have many exciting things about it. Perhaps it owns the tallest building in your city, which has an eco-friendly garden on the roof. Or it was the first to perfect a particular process. Or you just happen to like that company’s products. That is not enough of a reason to invest, or an indication that now is the right time to invest, or that it’s a good long-term investment.
[See: 13 Ways to Take the Emotions Out of Investing.]
The factors for investing in any holding should include considerations like: Does it benefit my current portfolio mix? How does it affect the risk/return profile? Is it low cost and tax efficient?
Active stock picking strategies are great places to find stories that sound reasonable, but are actually utter fiction. As convenient as it would be, unfortunately none of us have the ability to see the future. We can make educated guesses at best. Ignore statements like, “If we do not find support near the 2872 area, then I suspect the S&P 500 Index will likely drift lower to test the next level of support at the 50-day moving average near 2827.” In English, that jargon simply means that if the market doesn’t stop going down at 2872, then it will continue going down. It is nothing profound and essentially meaningless.
Anyone who predicts the future, whether it’s the weather person on TV or an investment prognosticator, is by necessity writing fiction.
So what can you do instead? When in doubt, apply the common sense test. Sometimes you have to pick through the jargon to parse whether it is actually saying anything at all. A particularly funny one is “It’s about being long in what is moving higher.” Well, of course. If we could all do that all the time, we would. If a particular story seems too good to be true — ask yourself why isn’t everyone doing it? Does the person offering it have any special expertise or real insight versus story around the investment? Typically, the fallacy will become obvious when you consider the potential investment with that approach.
Then think about your individual financial goals to back into what is required to achieve those goals. How much will you need to save? For how long? How much risk can you afford to take (or not) in the portfolio?
[See: 10 Long-Term Investment Strategies That Work.]
Your individual story is really the only one you should pay attention to when constructing your financial strategy.
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Ignore the Hype When Making a New Investment originally appeared on usnews.com
