Investing Myths and Disjunction Fallacy
Here are the results from a twitter poll I ran yesterday.
It was a small sample size. Only 30 people. I assume most were financially literate.
I wonder what people thought when they saw the results, after answering the poll. Did they feel more or less sure of their answer? Did they feel validated or perhaps confident in their contrary position?
It seems most people believe that a 50 percent loss takes a 100 percent to make it whole again. That a 90 percent loss takes a massive 900 percent to offset it.
That my friends is bullshit. It is one of the most widely perpetuated myths in investing.
Investing is a parallel pursuit. A 50 percent loss in one investment is offset by a 50 percent gain in another investment of the same size. A 90% loss is made whole by a 90% gain.
Yes if you loose 80% of your total portfolio you’ll need to make 400% to get back to scratch. While that concept is important, I consider focusing on outcomes for individual investments more crucial. I’ve always liked the saying, look after your pennies and the pounds will look after themselves.
There is no need to be terrified of losses. The upside is infinite the maximum downside is only 100 percent (ignoring leverage). I don’t wish to encourage you to be a bag holder and take big losses. My aim is simply to make you wonder why almost everyone is hell bent on convincing you that deepening losses require exponentially higher returns to offset.
Now for anyone thinking, but you didn’t say an investment I thought you were talking about a portfolio, let’s talk about disjunction fallacy.
In short disjunction fallacy is thinking that a member is more likely to be part of a subset rather than a member of the set which contains the subset. In the above poll, both 50% and 100% are subsets of it depends.
This is similar to the better known Linda effect or conjunction fallacy, when people guess that the odds of two events co-occurring is greater than either one occurring alone.
The return required to make you whole depends on whether you’re considering a portfolio or an investment and the position size of each investment.