He's closer than you think
A lot of investors out there feel like there's someone, or something, out to get them. A shadowy entity bent on depriving them of their hard-earned cash.
They're right. In fact, this stealthy offender is with them all the time, stalking them, watching their every move.
If you creep upstairs to the bathroom, very quietly, rolling pin in hand, you can even catch a glimpse of this miscreant. Tiptoes now. Toward the bathroom. Ease open that door. Flip the light switch and ...
Ha! See the culprit? It's the person staring back at you from the mirror.
Our own worst enemies
Investors torpedo their own portfolios for a variety of reasons: too little research, too little diversification, too much diversification. But I submit that the biggest culprit is none of these. It's the freak-out factor.
Prisoner of your emotions
Read a few articles about investing legend Bill Miller and you'll come across all kinds of 50-cent phrases, like the "Fallacy of Misleading Vividness," or the "Availability Heuristic." Simply put, this describes the human tendency to overweight the statistical probability of events that have a high emotional impact. Ever notice how vivid descriptions of a plane crash make you worry more about being part of one? That's exactly what we're talking about.
Miller (as well as other investing legends like Buffett, Munger, and Dreman) is interested in this phenomenon because of the opportunities it can create.
The fallacy of misleading vividness runs rampant on Wall Street all the time. Last year, about this time, American Eagle Outfitters (NASDAQ:AEOS) had a month or two of mushy same-store sales. The stock dropped like a rock as analysts succumbed to the fallacy and began issuing downgrades based on their belief that more bad news had to be on the way. They even contributed to the downward spiral by concocting all sorts of elaborately detailed fantasies of failure. The more vivid they got, the more the stock tanked.
Of course, they were dead wrong. American Eagle's sales were fine, profitability zoomed back, and those of us who bought on the panic have doubled our money in just a year.
Bad brains, part two
Of course, this phenomenon isn't limited to downside freakouts. We make the same mistakes when we get too cocky about our favorite product or store, then overpay for the stock because we're certain that the sky's the limit.
Fortunes have been lost by people who piled into Urban Outfitters (NASDAQ:URBN) simply because the one in their favorite mall always looked full. Ditto proud owners of Palm's (NASDAQ:PALM) Treo, or overly enthusiastic Vonage (NYSE:VG) users. (If Crocs (NASDAQ:CROX) shareholders don't meet the same unfortunate fate within a couple of years, I'll eat a pair of those ugly shoes.)
Blame your brain
Here's the roughest news. It appears that we're genetically hardwired to continue making this same mistake. Harvard psychologist Daniel Gilbert -- in a hilarious and informative book called Stumbling on Happiness -- explains that our brains consistently fool us when we try and predict the future.
Research shows that our ideas about the future are inevitably corrupted by our current emotional state. (Interestingly enough, our memories of the past are similarly suspect.) As a result, we tend always to project our impression of the present, whether we're looking back on memories or imagining forward, to the future.
Defeating the enemy within
Are we forever doomed to be too pessimistic in the face of bad news, and too naive in the throes of euphoria? I'd like to hope not.
The best way I know to avoid tripping on the fallacy of vividness is to stick to the most basic facts and numbers. What's the company doing? How much cash does it usually make? How much will it make down the road?
And most important: How much am I willing to pay for that stream of cash?
That's how I have always scored my doubles, like American Eagle.
No pipe dreams a la iRobot (NASDAQ:IRBT). No living by the worst-case scenario, say by ditching Dell (NASDAQ:DELL) because a couple of batteries caught fire. By removing as much emotion as possible from the process, you can come to a reasonable valuation of any stock. Insist on a 20% or 30% margin of safety, and your decision pretty much makes itself. That's the way market-beaters have always worked and that's the approach we take at Motley Fool Inside Value.
Let everyone else continue falling victim to the investing enemy within. You can learn how to outwit him -- with a month's worth of lessons and access to all past recommendations -- for free.
At the time of publication, Seth Jayson had shares of American Eagle Outfitters but had no positions in any other company mentioned. View his stock holdings and Fool profile here or see what he's Digging these days. iRobot is a Motley Fool Rule Breakers recommendation. Dell is an Inside Value and Stock Advisor recommendation. Palm and American Eagle are also Stock Advisor recommendations. Fool rules are here.
