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Hello friends and fellow Hivians,
Something you will see investors do, even experienced ones, is they often try to compensate their bad investment returns with a new investment with “better” returns.
Said in another way, I often see people do an analysis of their investments like this, "Ok… I lost a lot of money on investment A, what do I need to invest in to get back the money I lost?"
If you think in terms of fixing your old losses, you are not alone, if anything you are part of the majority; most people think this way, most companies will make decisions this way too.
Another iteration of this thinking is doubling down on an investment that lost you money. Sometimes it makes sense to buy more at a lower price, but it should be based on the investment thesis not how much you are in the red.
I realize this posts may come off as pretentious and I promise that is not my intention. I make plenty of mistakes and do fall prey to this way of thinking. If I make a bad decision and it losses me money, I do try to take that for what it is....it was my decision and I am responsible for the loss. But thinking this way is not easy; it's very challenging.
One way I combat this is, I make a habit of looking at my investments and most especially the ones with bad returns. I try to desensitize myself to my own losses. It hurts and it's absolutely terrible. I'm not sure if I recommend this, it can be really depressing.
But on the flip side, people need to remember that investing is not easy and once you “know everything” you are on the path to your own wealth destruction. Investors who have lost control of their ego make terrible decisions because they only focus on returns and no losses; they believe they cannot lose.
Circling back to my original point, why is trying to compensate bad investment decisions with new returns a bad strategy? It’s a bad strategy because it encourages you to take on riskier investments than you were originally comfortable with. In a prior blog post I talked about the Sharpe Ratio. You do not need to use the Sharpe Ratio when making every decision but you should know that high returns are usually associated with a high levels of risk.
So if you start pursuing the highest returns to compensate for old losses, now you only invest in the riskiest investments. If you only invest in the highest levels of risk, it's probable you will lose most of your wealth.
So how do you avoid this? Well the easiest way to avoid this is to familiarize yourself with the “Sunk Cost Fallacy.” It is when someone refuses to abandon an investment based on what they put into it. Well how much you personally invest in something does not dictate what returns you will receive. When people fall prey to the Sunk Cost Fallacy it is mostly just ego. They can’t admit they were wrong because it hurts; so they double down on the bad investment.
In Summary, if you want to make good decisions, don’t let the past dictate your future. Learn from the past, cherish your mistakes, without mistakes you will never learn and keep making the same mistakes over and over again.
Cheers! Much love and I hope to see you on the other side,
❤️ Hurt
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Thank you for this insightful information on the Sharpe Ratio and the Sunk Cost Fallacy.
I totally agree with you on that past losses should not, and must not, determine a future investment strategy.
Similarly, past profits should not determine future investment decisions either.
Those who rely on the past performance of various forms of investment, whether it may be losses or profits, in order to configure their future investment strategy, will inevitably end up with suffering either heavier losses or eliminating any profits that they have made in the past.
Personally, I believe that an investor should look for real value in any investment that he or she makes.
According to Professor Glen Arnold at Salford University, UK, a "valuegrowth investing" approach is strongly recommended, since this investment specialist defines himself as a "value investor".
No problem and thanks for the feedback! I believe you are right on profits too! Assuming your profit rate will stay the same is not a recipe for success long-term. I agree on the value investing piece as well; it's even an easier road than active trading.
But that isn't to dump on active trading strategies. There are profitable active trading strategies but they are usually temporary and require a lot of work to maintain.
Thanks again for the feedback!
!PIZZA
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Totally agree. I admit that I do suffer from these bad habits sometimes.. I guess we can only try to be as objective as possible but human beings will always have a certain level of emotion or perhaps ego.
!PIZZA
We all do! It's just part of the path. As you said yourself, we as humans have a certain level of emotion. Investing is very personal because it is your money on the line. It's a constant battle of wits with your own ego; sometimes we win and sometimes we lose. 🙂
But being honest with ourselves goes a long way and makes a big difference. In all things, not just investing!
!PIZZA
Hehe as long as we win more than we lose! :P
LOL! 😆....hey easier said than done but I think we will get there!
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