Sinister Story Stocks: Why You Shouldn’t Believe In Most Happy Endings

What do doctors, track handicappers, and investors have in common?  Read on to find out.

But first, let me ask you something:  Have you ever fallen for a story stock?

At first you think your stock will have a fairytale ending, but it ends up more like a tragedy. I know, it’s happened to me more than a few times.

Why do we keep believing in stories that refuse to come true?

The answer lies deep within the recesses of your mind, where some common psychological traps lie await for the unsuspecting investor.  If you want to learn how to avoid these traps, keep reading.

Irradicating the information illusion

Did you know that for diseases that are only possible to spot by considering combinations of symptoms, like gastric ulcers, a doctor’s accuracy is not very high?¹

Knowing that your doctor is not as accurate as you might think can be scary on its own.

What should really make you go scrambling for a second opinion is this: As your doctor learns more about your symptoms and conditions, he becomes more confident in his diagnosis.  What’s shocking is that his accuracy stays the same.

He becomes more confident, but not more competent.

The problem is not restricted to doctors, though.  Track handicappers face the same problem.  In one study, handicappers were given from 5-40 pieces of information they considered important for picking winning horses.  Their accuracy with five pieces of information was the same as with forty, but their confidence went to almost twice its original level!²

So what’s that got to do with choosing individual stocks?

Unsurprisingly, investors face the same problems processing increasing amounts of information.

It’s simple: the more background and facts you dig up about a seemingly kick-ass investment, the more confident in it you will become. That’s dangerous, especially because your accuracy in finding a true story stock probably hasn’t gone up at all.

Another study shows that professional investors do not correctly process extra information, even though their confidence goes up.³

You and me are the same.  The more we learn about a stock with a good story, the more likely we believe it will have a happy ending.

So what can you do to select stocks that really do have fairy tale endings?

That’s what the next post is about.  Read on to find out What Cinderella Can Teach You About Story Stocks With Happy Endings.

Or subscribe to Happily Ever After Investing so you can find real story stocks that will help you reach your own happy ending.

All of the below references were originally found in David Dreman's Contrarian Investment Strategies For The Next Generation, on pages 75-81 (New York: Simon & Schuster, 1998)

¹ Herbet Simon, Models of Man: Social and Rational (New York: Wiley, 1970)
² Paul Slovic, "Behavioral Problems Adhering to a Decision Policy," IGRF Speech, May 1973
³ Paul Slovic, "Analyzing the Expert Judge: A Descriptive Study of a Stockbroker's Decision Processes," Journal of Applied Psychology 53 (August, 1969) pp 225-263; P. Slovic, D. Fleissner, and W.S. Bauman, "Analyzing the Use of Information in Investment Decision Making: A Methodological Proposal," Journal of Business 45, no.2 (1972), pp. 283-301

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