How Emotions Get in the Way of Investment Decisions

In 1985, three cognitive psychologists published a study that enraged sports fans all across the nation. Thomas Gilovich, Amos Tversky, and Robert Vallone were curious as to whether or not the notion of the “hot hand” in basketball had any validity. They wanted to see whether a series of consecutive successful shots had any bearing on whether or not a player would likely make his next shot.

To answer this question, the researchers conducted four different studies:

  • They administered a survey to 100 basketball fans, confirming the existence of the belief that a player with a “hot hand” or on a “streak” is more likely to make his next shot.
  • They looked at the individual shooting records for every player on a team for an entire basketball season, noting the sequence of successful and failed shot attempts.
  • They looked at data from free throw attempts.
  • They performed a controlled experiment in which people made consecutive shot attempts outside the context of a game.

The psychologists found that there was absolutely no correlation between a successful shot attempt and the likelihood of a subsequent shot attempt being successful. The concept of “the streak” is an illusion.

Perhaps more surprising than the results of the study were the responses to it. When the psychologists published their paper, basketball players, coaches, and commentators were skeptical. Despite the indication of the raw numbers to the contrary, these people held on to their beliefs. Red Auerbach, historical coach of the Boston Celtics, said, “Who is this guy? So he makes a study. I couldn’t care less.” Bobby Knight, famous coach of the Indiana Hoosiers, said, “There are so many variables involved in shooting the basketball that a paper like this really doesn’t mean anything.” It didn’t matter that science and statistics were working against them. These people felt that the “hot hand” was a real thing, so they believed it.

The “hot hand fallacy,” as it has come to be known, doesn’t just occur in basketball. It happens everywhere, most notably perhaps in the world of investing. Investors make decisions, not based on well thought-out strategies, but rather on their emotions. They form psychological bonds with companies and artificially inflate the value of their stocks within their own minds.

Emotions cloud our judgment when making investment decisions. When we go with our instincts and make decisions based on what feels right, we are heading down the road toward disaster. You should never confuse the brand of a company with its stock price. Just because you like the commercials, the Facebook page, or the logo of a company, that doesn’t mean you should invest in its stock. But we are human beings and our emotions often get the best of us.

Often, the only way to resist the pull of your emotions is to solicit the aid of someone who is not experiencing those emotions. A good financial coach can help you recognize the pull of your emotions and steer you toward sound investment decisions. Contact us for a free consultation on understanding how to think more rationally in making investment decisions.