It's easy to feel like the billionaires have all the answers...
At TradeStops, we track the stock portfolios of multiple billionaires. Most of them are investment legends. Yet the data has shown that our software could have substantially improved their performances over time.
Why is this the case?
How is it that even the smartest investors on the planet can benefit from algorithmic rules, applied through user-friendly investment software?
It's about how the human brain works...
The markets are full of variables – too many for the brain to grasp. But that's only part of it.
The deeper problem is that people tend to draw the wrong conclusions from what they think they see. It's possible to have all the data and still come to the wrong conclusion. That goes for even the smartest investors in the world.
Daniel Kahneman, the Nobel Prize winner who pioneered the field of behavioral economics with his partner Amos Tversky in the 1970s, tells a great story to illustrate this point. Today, I'll share it with you, and explain what it tells us about how to defeat our own biases.
It has to do with Israeli Air Force pilots...
Kahneman was once tasked with teaching psychology to flight instructors in the Israeli Air Force. The goal was to improve the quality of flight instructor
Kahneman started off by telling the flight instructors about one of his most important findings: the fact that skills training works better with rewards than it does with punishments.
In other words, if you are trying to teach a skill, multiple studies have shown that you get better results from using praise over penalties.
But one of the most experienced flight instructors in the group thought Kahneman was dead wrong. This is what the seasoned flight instructor said...
On many occasions I have praised flight cadets for clean execution of some aerobatic maneuver. The next time they try the same maneuver they usually do worse. On the other hand, I have often screamed into a cadet's earphone for bad execution, and in general he does better on his next try. So please don't tell us that reward works and punishment does not, because the opposite is the case.
In his book Thinking, Fast and Slow, Kahneman called this "one of the most satisfying eureka experiences of my career."
He saw immediately that the reason cadet performance got worse after a good flight... or better after a bad one... had nothing to do with praise or criticism. Instead, it was a basic statistical concept known as "regression to the mean" – how performance tends to return to the average over time.
This means that if you have an exceptionally good performance – far better than your personal average – you will probably do worse next time (closer to your average) simply by random chance... and vice versa.
So, the flight instructor was right about one thing: Trainees tend to do worse after a good performance and better after a bad performance.
But the instructor completely missed the fact that this pattern is grounded in normal statistical probability.
Kahneman wanted to show the flight instructor why his thinking was wrong...
He drew a target on the floor with a piece of chalk. Then, he asked all the flight instructors to turn their backs and throw coins at the target without looking.
Kahneman analyzed the coin-toss results on a blackboard. The instructors who did worse than average on the first toss mostly did better on the second try... And for the instructors who did better than average on the first try, the results were reversed.
It turned out the flight instructor's response was a classic example of cognitive bias... a false assumption rooted in how the brain works.
This kind of thing happens all the time (not just in the Israeli Air Force)...
Human brains aren't naturally wired for statistics or probability. So, we tend to go with what we "see."
The biases and flawed perceptions in play here are built into every human brain. Overconfidence and pride can make the cost of these biases worse – so staying humble is also a form of risk management!
Almost every investor can benefit from a set of algorithmic rules, existing outside his brain, to help with the process of decision-making.
These algorithms don't take over the decision-making process completely... They can simply provide valuable input, particularly in areas where the brain needs assistance.
All of which helps explain why TradeStops has the potential to help almost any investor... even the investment-legend billionaires we follow.
Dr. Richard Smith
Editor's note: Richard is hosting a live event to discuss his latest breakthrough on Tuesday, July 31, at 8 p.m. Eastern time. You'll learn a little-known way to find stocks setting up for a breakout... how to sort through the portfolios of legends like Warren Buffett to find the best opportunities... and where the markets could be headed next. Reserve your spot for free right here.
"Most people take this idea way too far," Steve writes. He's talking about a different kind of cognitive bias. If you're an investor, make sure you're not falling into this trap today... Read more here: This Hasn't Burned Your Portfolio Yet... But It's About To.
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