Investing without understanding how your brain is making decisions is a waste of time. It’s also a waste of money.
In this post, I’m going to reveal a few powerful concepts that will change the way you think about investing. Applying these concepts will make you a better investor in the long run.
My failed investment
When I was younger, I made tons of impulsive investment decisions. Not just with stocks either. In college, I thought it’d be a great investment to buy Teenage Mutant Ninja Turtle action figures. The figures were still in their original packaging. I figured I’d buy them in bulk, then sell them off one-by-one for huge profits. Great idea, right?
As it turns out, the market for buying toys wasn’t as I’d predicted. Most of the people buying figures on eBay were re-sellers like me, hoping to make a quick buck. So nobody was actually buying. I ended up losing money on the investment, having to re-sell most of the figures in bulk for a loss.
Looking back on the investment, I know it was stupid. It was impulsive. I didn’t do any research. It didn’t make any sense. So why did I do it?
You’ve most likely been in this situation before. You buy a stock (or some other type of investment) and it loses value. After you’ve taken your loss and moved on, you can’t help wonder why you made that investment to begin with. Was it someone’s advice? Were you drawn to the company’s products? Did you think you were beating the market?
Nobel Prize winner Daniel Kahneman wrote an excellent book called Thinking, Fast and Slow. The book discusses the psychology behind how our mind works. The research in the book applies to investing, as well. Let’s take a look at some of the concepts and how understanding them can make you a better investor.
Concept one: Your two minds
Our mind has two systems that process information. It affects how we think, come up with decisions, act, and judge situations. This is crucial when you’re investing. The first is system one. I like to think of it as our “lazy brain.” System 1 is the part of the brain that reacts on intuition. It’s impulsive and automatic. It’s non-conscious.
For example, you might buy stock in a company just because they have a sexy new product out. You think it’ll change the way consumers behave. You don’t care to dig into the company’s financials or history right away. Your system one mind is drawn to the story and leads you to make an impulsive, lazy decision.
To explain this a little further, I’ll use the example from the book:
A bat and a ball cost $1.10. The bat costs a dollar more than the ball. How much does the ball cost?
More than likely, you said 10 cents. This is your system one working, but it’s incorrect. If you take a moment to do the math, you’ll find that the answer is five cents. So what happened? Your system one relied on impulse to answer the question you thought was simple.
How might this affect your investment decisions.
The second type is system two, and it’s more conscious. It requires effort. It’s the part of our brain that will allow us to focus our attention. We can then make deliberate, thought-out decisions. But it also requires that you set your impulses aside and concentrate.
Let’s take another look at the example above. If you’re using your system two, you may make a different decision on the stock. You may stop yourself from buying the stock after analyzing the company’s financials. Or you may notice they have many competitors and a small, unsustainable profit margin.
My system one was the primary driver of my investment in Ninja Turtles action figures. I bought the figures on impulse. I ignored the costs. I ignored the potential lack of profitability. This was all for the allure of buying and selling toys from my childhood.
Key Takeaway: Train your brain to be less lazy and use your System two more often. By doing this, you’ll increase the strength of your intelligence. You’ll also become more focused when you make investment decisions.
Here are five excellent brain-training apps for you to try right now:
Related: Forget buy low, sell high: This simple investing strategy yields even better results
Concept two: Priming
Priming is a concept where certain words, images, or objects can affect our brain. This impacts the way you make decisions.
For example, when you think of coffee, the first brand or company most of us think of is Starbucks. That’s because our culture and society have “primed us” to do so. Everywhere we look, we see logos and ads for Starbucks. We see people on TV drinking Starbucks while walking through New York City. This is priming us to make associations to coffee when we see or hear certain words.
Let’s say you want to invest in a coffee company. Using the example above, you might think of Starbucks as the best investment. But this could be due to the priming you’ve experienced. You may think Starbucks is the best investment because everyone drinks it. You may also associate Starbucks with New York, and New York with wealth. This may cause you to look past a smaller coffee company that’s a better investment.
Priming is a normal byproduct of the culture we live in. It pushes us to make investment choices we may know nothing about. It occurs all the time, yet we do it without even knowing.
Key Takeaway: Research the company and its industry in-depth before investing. Slow down and think (use your system two) before running out to buy one of the “10 Hottest Stocks for Christmas.” You might be getting primed.
Here are two of the best resources for learning about a company:
- EDGAR Database: financial data for any publicly traded company
- Yahoo! Finance and Yahoo! Finance Markets: both great resources for learning more about your company, its competitors, and the market its in
Related: How to get over your fear of the stock market and start investing
Concept three: Snap judgements and oversimplification
Two main concepts can affect how you choose investments. The first is the halo effect. This is your mind’s lazy tendency to associate two unrelated things. It can be a person, object, or situation and is usually a result of a previous thought or data point you have.
For example: You own an iPhone, MacBook, and iPad. You’re an Apple fanatic and you love their products. Because of this (and this only) you think that Apple would make the best cars. Yet just because they make excellent electronics doesn’t mean they would make excellent cars.
The second concept is the confirmation bias. This one is dangerous and happens often. It’s the tendency for us to agree with suggestions and opinions that are in line with our own beliefs.
For instance, let’s say that you think that Miller Lite is a good beer. Let’s say I am a renowned beer expert. If I told you that Miller Lite was not only the best beer, but it was also good for you, you would agree with me. More than likely, you’d now think that Miller Lite was the best beer, not just a good beer. Your opinion was now confirmed by me, the expert.
Key Takeaway: Know your company inside and out, then form your own opinion. Use the resources from concept two as a baseline. Then take it a step further by looking at more in-depth analysis. Look at things like a stock’s risk rating, historical data and trends, and analyst’s research reports.
Here are three well-respected premium stock research sites for you to look into:
Related: Best Investment Accounts For Young Investors
At the end of the day, you need to decide how important investing is to you. Are you okay with making lazy, impulsive decisions? Or would you rather put in a little time and effort to make a more educated decision?
Whether you’re investing in Zhu Zhu Pets or stocks and bonds, understanding these concepts (and applying techniques to make your brain work for you) will make you a better investor in the long run.
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