Is Your Brain Costing You Money?

Several months ago, I bought Nutrisystem (Nasdaq: NTRI) stock in the mid-$40s. I though it had been oversold after a first-quarter report that was good, but not good enough for the Street. Although the growth rate was slowing a little, the business and cash position looked very strong, and it looked like a candidate for a nice bounce. I bought a block and set a mental target of $70, thinking I'd reevaluate the stock when it hit that point -- and thinking it likely that I'd end up selling.

Well, a few months passed, and Nutrisystem bounced -- right over $70, in fact, looking strong as it ran toward second-quarter earnings. I was surprised it had happened so quickly, and quite pleased with myself for picking such an excellent stock.

In fact, I had started to believe it could go even higher. I had read a report from an analyst that gave a "price target" of $92, and I got a little fixated on that number. It's still undervalued, I told myself. I went back over the financials, looking for evidence to support that idea. Naturally, I thought I had found some, and I sat back to await my even bigger profits.

You know what happened next, right? The stock plunged right back down to the mid-$40s. As of this writing, it's trading around $54 -- a nice profit were I to sell today, but not exactly the double I had come to expect.

What'd I do wrong?

Owning my biases
I initially bought the stock because I had a good first impression of it -- I read an article suggesting that the stock looked cheap relative to its prospects, and I confirmed that impression after some research. As the stock was going up, I read that analyst's report and anchored on that $92 target, mentally adjusting my expectations and getting lost in confirmation bias as I reevaluated the evidence, looking for points that would confirm my expectations and discounting information that argued against it. As a result, I failed to sell at my initial target of $70 -- which I'd arrived at more or less rationally -- before the stock slid back down.

First impression biases, anchoring, and confirmation bias are well-known (and well-studied) tendencies in behavioral finance, the study of why people do what they do with their money. Although I didn't get too badly burned in the Nutrisystem example, it's easy to imagine a situation where I might have. Suppose the fundamentals really had deteriorated after I'd bought it. Suppose the price had fallen into the $30s. Would I have seen the evidence of deterioration, or would I have been selectively reviewing the evidence to find points that would confirm my first impression?

Think about your own recent stock-picking history. Do any of these tendencies ring a bell?

It's not just about stocks
These tendencies can cost us money in a lot of ways, not just with stocks. About 20 years ago, two professors at the University of Arizona did a study with real estate agents in Tucson. They randomly chose two separate sets of real estate brokers and took each to look at a house to appraise its value. The first set of brokers, knowledgeable professionals all, got a guided tour and a 10-page packet of information that included the house's "list price" of $65,900, and gave an average appraisal of $67,811.

The second set of brokers got the same tour and the same packet, There was just on difference: The list price in their packet was $83,900, and their appraisals came in considerably higher -- $75,190, on average. Clearly, the study concluded, the brokers had anchored on the price in the packet and looked for information to confirm that bias.

The upshot
What to do? It's very hard to be completely objective when making decisions about one's own money. But if you can develop the skill of watching your thinking, and if you can be aware of common ways in which our minds develop biases, you can learn to make better, more objective decisions -- and better decision-making will improve your investment performance in the long run.

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If you'd like to learn more about confirmation bias and other bits of behavioral finance, Fool contributor John Rosevear heartily recommends Why Smart People Make Big Money Mistakes -- and How to Correct Them by Gary Belsky and Thomas Gilovich, from which he learned about the University of Arizona study. John owns shares of Nutrisystem. The Motley Fool has a disclosure policy.