Are You an Irrational Investor? Fix Your Strategy Right Now…

‘It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness…’

A Tale of Two Cities, Charles Dickens

Do you remember the 1990s? It was an exciting decade. We saw the Berlin Wall crumble and the Soviet Union go bust. Computer-generated movies like Terminator 2 and Jurassic Park hit mainstream cinema. Grungy fashion took hold in the form of flannels and Doc Martens. Japanese cultural exports like Tamagotchi and Pokémon became worldwide crazes.

And, oh yeah, amidst it all, there was this little breakthrough called the internet.

Yes, the internet…

We kind of take it for granted now. But remember: the internet was cutting-edge tech back in the ‘90s. It encouraged sweaty palms, racing hearts and soaring imaginations. Through the wonders of dial-up modems and copper telephone wiring, anyone could connect to the World Wide Web. The potential seemed dizzying and endless.

Naturally enough, internet businesses exploded. Seemingly overnight, a flood of new companies went public. Some of these names are legendary, and chances are, you will feel a touch of nostalgia at the mention of them…

AOL. eBay. Yahoo. GeoCities. Excite. Lycos. Netscape…

The internet was boiling hot. And it created a feverish stampede as people snapped up shares in any dot-com company. Financial speculation became rampant, and confidence in this ‘new economy’ skyrocketed.

As a result, the NASDAQ index peaked in March 2000, hitting an astounding 5,047.62 points. The mood was jolly as employees and executives at dot-com companies became overnight millionaires. This juggernaut seemed unstoppable…

And then…it suddenly ran out of steam, and it all came crashing down in dramatic fashion.

I’m talking gasp inducing and groan worthy…

In October 2002, the NASDAQ plunged to 1,114 points, down 78% from its peak.

In the horrific aftermath, over 50% of internet companies collapsed, and fortunes were wiped out.

One of the most prominent casualties was Pets.com. This was a classic case of hubris, if there ever was one.

Pets.com first began operating in November 1998, riding a frenzied wave of publicity that saw it list on the NASDAQ in February 2000, raising a whopping $82 million. From Super Bowl commercials to Thanksgiving parades — Pets.com was seemingly everywhere.  

At first glance, Pets.com had a really attractive business model — it was an online store dedicated to delivering pet food and supplies quickly and efficiently around America. It was, quite literally, ‘Amazon for cats and dogs’.

However, there was a serious flaw with the Pets.com business model — the management just couldn’t find a cost-effective way to ship heavy bags of animal food to individual customers around the country. This meant that profit margins were razor-thin, which was compounded by the fact that they had blown an enormous chunk of their money on advertising.

In the end, sales performance proved to be abysmal. And the share price for Pets.com plummeted — falling from a high of $14 to a low of 22 cents. That’s an astounding 98% nosedive.

Pets.com failed, and it failed big-time.

All across the dot-com landscape, the story was pretty much the same. You had ill-conceived business ideas which sounded catchy in theory, but soon fell apart when faced with harsh reality.

All in all, investors lost an astounding $5 trillion in market value. It’s a stock-market crash so epic, so catastrophic, that it begs the question:  how could it ever happen? How did so many smart people get it so wrong?

First impressions matter…

Now, as human beings, we like to think of ourselves as being fair-minded, mature and rational. This is especially true when it comes to life’s big decisions. We feel like we know best, and we go with what our wise instincts tell us to do…  

But, increasingly, the latest neurological research shows that we’re not as wise as we think are. In fact, we’re actually prone to exaggeration, distortion and fantasy. And most of the time, it’s happening without us even knowing it.

The first big problem is known as ‘confirmation bias’. We see what we want to see, and we train ourselves to dismiss information that conflicts with our pre-existing beliefs.

A good example of this happened recently in the United States. Payless ShoeSource, an American budget shoe retailer in Los Angeles, tricked unsuspecting shoppers into spending over $500 for footwear that only had a retail value of around $20.

Payless did this by opening up a fake pop-up store with fancy décor, where they displayed a range of shoes apparently created by a fake Italian mogul named Bruno Palessi. Then they organised a grand launch, inviting everyone from fashionistas to designers.

When these folks were interviewed on camera, they gushed about the quality of the Palessi brand. They used words like ‘stunning’ and ‘elegant’ and ‘sophisticated’. They were incredibly earnest and totally convinced.

That’s when Payless staff took these shoppers to the backroom and gave them the big reveal: it was an elaborate prank. These experts in high fashion were left astonished. They couldn’t quite believe how they had allowed themselves to be hoodwinked.

And yet…what happened here is entirely predictable. Good packaging and good promotion can create a mythology that overrides our common sense. Our reality and judgement is swayed.

It can happen with shoes just as easily as it can happen with stock bubbles.

Stubbornness doesn’t pay…

Now, the second big problem we face is known as the ‘backfire effect’. When someone challenges our core beliefs, we tend to become defensive. We dig in our heels, and we cling on to our opinions even more strongly.

Much of this comes down to our prehistoric caveman roots. We cluster ourselves in tribes for both safety and sustenance. It’s good…but only up to a point. It becomes a problem when we defer to the rule of the mob even when we should be thinking for ourselves.

Here’s a good example. Back in 1997, just as the dot-com bubble was gaining speed, Warren Buffett expressed his scepticism about overpriced internet stocks. He couldn’t find a plausible reason why companies with awful business models were surging on NASDAQ index — except to conclude that it was all based on blind emotion.

People were buying because, well, other people were buying. This was a ridiculous trend that just couldn’t be sustained.  

Most pundits, of course, refused to listen to Buffett’s analysis. They sneered at his old-fashioned grandpa wisdom. They dug in their heels. They believed that the internet was a bulletproof investment.

But we all know how that story ends. The dot-com bubble eventually popped. There was an avalanche of tears and broken hearts.

Oh, what needless pain…

So what can you do to get wiser?

Here at Money Morning New Zealand, we’re all about offering you a contrarian view. That means we’re determined to set ourselves apart from the mainstream. Our views are always provocative but backed up by good reasoning.

Our goal? To study the financial landscape, outline the threats, and chart a path forward for you to take. So that you can make an informed decision and create a safer and more prosperous investment portfolio…

In the words of the Warren Buffett, ‘Be fearful when others are greedy and greedy when others are fearful.

So forget tech bubbles. Forget following the crowd. Think for yourself. The best opportunities are those lying on the fringes on the mainstream. And we aim to show them to you…

Regards,

John Ling

Contributor, Money Morning NZ

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