The Danger of Anecdotal Evidence in Investing

Stop me if you’ve heard this one before. You’re telling a coworker about a problem your kid is having in school, and your coworker says something along the lines of, “I know this guy whose kid was doing ‘x,’ and he started having his kid do ‘y.’ Then ‘z’ happened, and his kid straightened right up.” Or perhaps you’re out buying a car and the salesperson begins telling you a story about how the model you are test-driving once saved a customer’s life in a near-fatal collision. Then again, maybe this example will hit home with you. A friend tells you about a new social networking startup that he invested in and ended up making a lot of money; he then advises you to invest in a similar company that has just launched.

It’s easy to buy into these kinds of arguments. “If it worked for someone else,” the reasoning goes, “why wouldn’t it work for me?” Should you take the parenting advice? Should you buy the car? Should you invest in the startup? Perhaps it is true that you should do all of these things, but you should absolutely not do them for the reasons provided. Here’s why…

These arguments that we so readily believe without questioning are known as anecdotal evidence. This type of “evidence” is faulty, because it relies on one specific case study, example, or story to confidently make a judgment about a general trend.

In the examples above, you don’t want to know what happened with the specific child, you don’t want to know what happened with that specific customer, and you don’t want to know what happened that one time your friend invested. Instead, you want to know what typically happens with a certain method of parenting, you want to know how well the car usually performs, and you want to know what the general case is when you make such investments as your friend did.

When you are making any decision, especially if it’s a decision about how to invest your money, you can’t generalize based on individual stories. It’s basic statistics. If you have a broader sample from which to draw your conclusions, you will stand a much greater chance of being right. And I’m willing to bet that any statistician will tell you that a sample size of “one” is not very promising.

There’s also another thing that may cause you to reconsider making investing decisions based on anecdotal evidence–and it has to do with human psychology. Our minds are programmed to notice changes to our environment. Therefore, when we make a single observation about a company or stock, we are most likely noticing the exception rather than the rule. We are noticing what has changed while, when it comes to making investment decisions, what we really care about is how the company or stock usually performs.

There is a lot of anecdotal evidence being propagated by the media like Wall Street, as well as by pundits in the financial industry. If you need help sorting through the clutter and understanding how to make sound investment decisions, feel free to reach out to us for a free consultation. We would love to help you find the evidence that counts.