Investors who celebrate wins are doomed to disappointment

Pleasure over a big gain, instead of rational analysis of process, can lead to overconfidence

Dec 11, 2013 @ 9:39 am

By Daniel Crosby

Let's pretend for a moment that you have agreed to be a part of a study I'm conducting. I bring you into a room and present you with six Impressionist works of art. I then ask you to rank the six paintings from 1 to 6, with 1 being your most preferred and 6 being your least preferred. I further explain that you'll be able to leave today with a painting of your choosing.

Now that you've completed the ranking assignment, I tell you that you can choose any one of the six paintings. Naturally you choose number 1, since it was your most preferred, and I retire to the back of the room to retrieve it. I return shortly with a worried look and apologetically tell you that the paintings you ranked 1, 2, 5 and 6 are all picked over, leaving the ones you ranked 3 and 4 remaining. You can still have your pick of either 3 or 4, and you decide on 3 given that it was your slight preference.

Now imagine that I give you two weeks off and invite you back into my office to rank the same six paintings in order of your preference. What do you hypothesize will have happened? Would your preferences remain the same or would they have shifted? What might account for them changing or staying the same?

If you are like most people who participate in this experiment (commonly referred to as the “free choice paradigm”), your preferences will have changed upon your return. Typically, we see the painting that was chosen, previously ranked No. 3, will have progressed into the No. 2 spot. Conversely, the painting that was not chosen, previously ranked No. 4, will have fallen into the No. 5 spot. What accounts for such a dramatic change over such a short period of time? After all, both of the paintings represented a sort of middling preference, neither greatly prized nor greatly disliked at the initial ranking. So how they have migrated closer to the respective poles? Once again, the answer lies in our need to be special and to think of ourselves as competent, capable decisions makers who make choices based on rational criteria.

Dan Gilbert, Harvard professor and happiness researcher extraordinaire, describes the thought process of participants as follows: “The one I got is really better than I thought. That other one I didn't get sucks.” Once the participants have adopted an opinion, they begin to construct a list of reasons why their choice was the right one. Perhaps they tell themselves that they prefer the shading, or the texture, or the way the painting frames a previously blank space in the living room. Whatever the specific reasons, we are prone to build up our decisions immediately upon having made a commitment. What's more, we play the other side of the fence and begin to mount an offensive against the road not taken. We are at least as tenacious at tearing down the unchosen option as we are at building up our commitment — just ask anyone who has ever been broken up with by a partner that he or she “didn't like anyway.”

This all-too-human tendency to exalt our decisions and abase the road not taken can have disastrous consequences for investors, however. Ideally, investors would be learning from each financial decision, coolly determining whether or not they'd made the right decision and resolving to learn from their mistakes going forward. This becomes impossible though when every decision is accompanied by a flurry of self-congratulation. What's more, it leads us to attribute picking a winning stock as skill and choosing a dog as bad luck. This sort of misattribution is what leads investors toward overconfidence, a lack of appropriate balance and excessive churn.

It is only as we learn to rely on an appropriate investment strategy and begin to grade processes rather than outcomes that we begin to move beyond this need for self-praise. After all, if the choice is between false feelings of security and enhanced personal wealth, I know which option I'd prefer.

Daniel Crosby is a behavioral finance expert who works with organizations to develop products and messaging to maximize positive investment outcomes.

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