Jason has been following a company stock for the past year. It’s a great company with solid management, high sales growth, and consistently high earnings. It is in a booming industry sector and a favourite of the media. After a year’s worth of careful deliberation, Jason has decided to pull the trigger and buy a large position. He can’t see what can go wrong. What can go wrong? It’s a good company, right? Behavioural economists, however, point out that a good company may not be a good investment.
The human mind has limits. In order to sift through a variety of information, we take shortcuts. One of these shortcuts is called the representativeness heuristic. It works something like this. If it looks like a dog, acts like a dog, and barks like a dog, then the animal walking beside you must be a dog. Similarly, one might understandably think that if it looks like a good company, then it is a good investment. But it may not be a good investment.
We all want to invest our money in stocks that will continue to rise. Many investors are constantly searching for stocks that will continue to rise. When we see a company that makes profits and beats analysts’ forecasts, we tend to think it will continue to build momentum. But this conclusion may be the result of a decision-making bias.
When we make this observation, we are assuming that what we see at the moment “represents” future performance. In other words, if it looks like a company that will make a profit in the future, in that it was profitable currently and in the past, then it is a company that will make profits in the future. But history only repeats itself when it does. There are many reasons, however, that the company will fail to make profits in the future.
First, it’s difficult for any company to maintain high earnings. Second, a company can have significant management changes that may impact future earnings. A management team, for instance, can push itself to make tremendous profits in the short-term, but over time, they may become worn out and profits may wane. The company may be at a high point, and if it is, regression toward the mean eventually sets in, and the stock price declines along with profits.
Informed decisions are vital for financial success. Don’t engage in stereotyped thinking. A company may seem like a good investment, but upon careful consideration, you may decide that a company’s high performance may be short-lived. In that case, you may want to go short or sell off an existing position to the masses while there are still a group of enthusiastic buyers. What you don’t want to do, however, is be caught off guard, buying as the masses are buying and selling when there is no one left to push the price higher.
The human mind has a tendency to gloss over details rather than carefully considering the long-term factors that may push the price of a stock higher and higher. Be aware of decision-making biases that may undermine your trading plans. If you can carefully think through all possibilities, you’ll beat out the masses, and take home huge profits.