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Magical Thinking is a Poor Investment Strategy

June 12th, 2007 at 03:50 am

At the risk of losing some readers, I'd like to post my views on the dangers of succumbing to "magical thinking" when analysing the performance of your investment strategy, or when deciding on making a particular investments.

In my view investing should be a rational, logical process in which all available (at a reasonable cost in money and time) data is analysed. This data includes historical investment/asset class performance (return and variability), known constraints (tax laws, how credit ratings and borrowing limits are calculated and used, details of investment fees etc), and well-tested investment hypotheses (such as benefits of diversification, effects of asset allocation on return and risk, efficient frontier, etc.). There's enough uncertainty introduced into the investment decision making process via dodgy annual reports, truly random events, and investor herd psychology without making your own thought processes more 'messy' than need be.

It is also beneficial to bring a historical context to your analysis by reading up on previous booms and busts (the "madness of crowds"), scams and schemes (eg. Mr. Ponzi, Bros. Hunt) and so on, so you can avoid making mistakes that so many others have made before you.

What isn't useful is to indulge in what is known as "magical thinking" - that just by really, really wanting something to be so, it will become so. This covers a wide range of common practices, some obvious and some not so obvious. To go through some that I think are likely to hurt you investment performance:

* Prayer. Although it does no harm for a devote person to pray for financial success in general terms, praying for divine intervention when your forex trade is rapidly heading south seems to me to be a recipe for disaster. Just as it seems silly when players on both sides of a football match pray to win their match (although praying not to get hurt during the match seems OK). Better to try to be objective and know when to cut your losses. This isn't to say that there's no place for faith in investing - your beliefs may place valid constraints on your investment choices eg. not investing in unethical businesses, how you choose to distribute your wealth to charity etc.

* Positive thinking. A positive attitude and an acceptance of some risk will probably help you grow your investments in the long term. But thinking that positive thoughts alone can "make" good things happen won't. I'd put the "Law of Attraction" in the same category as talking to your houseplants to make them grow. It might make you feel better, but is unlikely to improve you net worth. (I'm tempted to say it's a total waste of time, but, like many beliefs, it's strength lies in the lack of any testable hypothesis).

* Looking for the secret to success. Many people will try a succession of different investment theories - going from charting (with a vast array of potential "indicators" to work through before admitting defeat), through to theories based on some measure derived from 'fundamental' analysis (the "Zulu" principle, "Dogs of the Dow", PEG, High Dividend Yield, High Growth, Small Cap, Large Cap, Emerging Markets, BRICs, whatever). While I'm sure many of these techniques work for some investors some of the time, it's very hard to tell if any of these successes are due to a real "insight" that will provide you with outperformance in coming years, or were just a random event. It will be a bit late to decide in 20 years time that the various methods you experimented with didn't work after all. And bear in mind that some techniques may be legitimate, but only if you have access to the correct data and the necessary computational tools and techniques. For an individual investor, the cost of getting the required data and time to do the required analysis or calculations may be disproportionate to the absolute gain that can be produced, given the amounts that are being invested. On the other hand, if the techniques and tools will be applied repeatedly to improve future results, it may be a reasonable investment in your investor education.

* Other irrational techniques. This would cover a whole range of common inputs into peoples decision making such as Astrology, Numerology, Feng Shui, urban myths. It's important to try to differentiate genuine underlying principles (bearing in mind that they may still be based on historical evidence and not apply in the future) from "rules of thumb" that are really just over generalisations. Sometimes its hard to tell the two apart.

Enough Wealth

1 Responses to “Magical Thinking is a Poor Investment Strategy”

  1. shadon Says:

    I don't know, seemed to work for Melburnian Rhonda Byrne. I'm sure she magically thought "I hope a stack of really gullible people by into this whole "The Secret" thing and make me really really rich. And lo and behold, millions did...

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