Investing Psychology Chapter 3: The Situation Trap (Part 1)
We like to think of ourselves as independent thinkers. The “American Dream” is built on the idea that you can do anything if you just try hard enough. But in Chapter 3, Tim Richards shows us that we’re heavily influenced by the situation we’re in, often without even knowing it.
The Beauty Premium
Did you know that attractive people earn about 10% more than average-looking people in the same job? This is the beauty premium.
We suffer from the halo effect. If someone is good-looking, we unconsciously assume they’re also smart, trustworthy, and good at their job. This is why financial advisors always look so polished. If your advisor looks like a movie star, be careful—you might be trusting their jawline instead of their track record.
Corporate Halos
Corporations use the same trick. During the dot-com bubble, companies would add “.com” to their name and watch their stock price double overnight. They didn’t change their business; they just changed their “outfit.”
Investors fell for it because of the halo effect. We anchor onto one positive feature and let it bleed over into everything else.
The Contrast Principle
If you’re looking at a $100 stock and it drops to $70, it looks like a bargain. But is it?
You’re just contrasting the new price with the old one. This is the contrast principle. Scammers use this all the time. They’ll show you an overpriced “decoy” first so that the second thing they show you looks like a steal. In the market, a “cheap” stock is only a bargain if the underlying value is still there.
George Soros and Reflexivity
George Soros has a theory called reflexivity. He says that markets aren’t just inanimate objects we observe. We are the markets.
If enough people believe the market will crash, they start selling. Their selling causes the market to fall, which “proves” they were right, so more people sell. It’s a self-fulfilling prophecy. Your own actions change the environment you’re trying to predict.
The Lesson
Don’t be a “reflexive” part of the herd. Understand that the situation—the “buzz” around a stock or the charm of an advisor—is trying to override your logic.
In the next post, we’ll look at how the weather, social media, and even the sheep population in Bangladesh can mess with your portfolio.