Why We Tend to Trick Ourselves into Making Bad Trades

Hans Christian Andersen recorded a folktale about a poor farmer who takes his horse to market to sell or exchange for something that will be more practical for his farm. But on the way to his destination, the Old Man (as he’s known in the story) makes a series of ill-advised trades. In each case he makes a swap for something of lesser value until, ultimately, he has traded his horse for a bag of rotten apples.

His saving grace is that when he gets back home his wife doesn’t scold him but instead says, “What the Old Man does is always right.” This mild response wins a bet the farmer has with two Englishmen who had wagered a bushel of gold that he would get clobbered.1

In addition to the lesson about supporting your spouse when they make mistakes, the folktale also illustrates how emotions can cause people to use poor judgment when making trades. In each of his lopsided deals the Old Man always has what seems like a very practical reason for making the exchange.

Taylor Tepper, a financial journalist for Forbes, writes that when the vast majority of us try to trade stocks for short term gain, we do a horrible job. “We sell them when we should buy,” he says, “buy when we should sell, and are overly influenced by the noise around us.”2

The problem, as multiple studies have shown, is rooted in our psychology. Our innate bias in favor of our own abilities and our aversion to loss work against us when we determine when to make trades.

One psychological bent that behavioral economists have identified is known as Prospect Theory. It’s the irrational belief that something that has lost value is sure to regain it soon. This behavior stems from our aversion to loss and results in holding onto declining assets when the rational choice should be to cut our losses.

A related phenomenon is known as Mental Accounting. This is the tendency to stash different types of gambles into completely separate mental accounts. As a result, we tend to judge each wager by its own rules, leading us to make special exceptions in contrast to logical decision making.

It’s hard enough to try to beat the market. And when your emotions get in the way of a methodical strategy, your chances of coming out ahead are very low.

This is why Meir Statman, professor of finance at Santa Clara University and someone who has studied investor bias for decades, says investors are not wise to buy individual stocks for two reasons. First, they lose out on the benefits of diversification. Second, trying to beat the market can produce a lot of anxiety.

“I learned to shrug my shoulders when markets go up or down,” says Statman. “Wise financial behavior and good exercise.”

The prudent investor understands the best way to pursue potential long-term gains in global markets is to stick with a diverse portfolio guided by evidence rather than emotion. And the best way to accomplish this is with the help of a trusted advisor.

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