Relevance Realization: The Key to Understanding Investor Under performance

While it's commonly acknowledged that many investors, even the pros, often underperform, the reasons aren't always clear. They say even a monkey randomly selecting stocks could outdo the experts. Common reasons cited for this disparity include:

• Recency bias
• Underestimating risk
• Market timing attempts
• Confirmation bias

Yet, I propose that these factors all spring from a central issue: Relevance Realization. This cognitive science concept, introduced by Dr. John Vervaeke of the University of Toronto, may hold the key to understanding investor behaviour.

What is Relevance Realization?

At its essence, Relevance Realization is our brain's ability to hone in on what matters, setting aside the extraneous. Amidst a daily barrage of information, distinguishing between the vital and the trivial is crucial.

Take reading, for instance. As you go through this piece, you're absorbed in its message, not being sidetracked by factors like font size.

Relevance in Investing

It's not that investors can't focus. A diligent stock analyst might scrutinize metrics like earnings per share, revenue trends, or company specifics. However, recognizing importance doesn't equate to recognizing relevance for the moment.

This misalignment becomes evident in biases like confirmation bias, where investors favour information aligning with their pre-existing beliefs. Similarly, recency bias could lead one to give undue weight to the latest trends, sidelining historical data. Such biases, I say, stem from struggles with Relevance Realization.

Wisdom from the Masters

Warren Buffett stands out as someone seemingly attuned to what's genuinely relevant. He grasps foundational truths like:

• Ensuring valuable returns.
• Understanding that market volatility isn't the real risk and that history doesn't always foretell the future.
• Seeing stocks as more than just numbers—it's business ownership with inherent profits and losses.
• The paramount importance of preserving capital.

Each of these insights carries profound implications that extend beyond their surface meaning.

The Weight of Losses

The imperative of minimizing losses cannot be overstated. If you lose 20% of a $100 investment, you're down to $80. To get back to $100, a 25% gain is necessary.

A more severe 50% loss? You'd need to double your money. The lesson is evident: recovery becomes exponentially harder as losses deepen.

Consider a contrasting scenario: a 50% growth of $100 takes you to $150. But a 33.3% loss pulls you right back to $100. The ups and downs aren't symmetric, underscoring the fragility of gains.

It's in human nature to sometimes downplay or dismiss looming challenges. But history, like Sir Isaac Newton's losses during the tulip mania, reminds us that no one is exempt from these cognitive traps.

This exploration into the intricacies of investor behaviour, particularly the role of Relevance Realization, remains an ongoing passion project for me. Future iterations will expand on this subject, supported by cited research, references and the Solution.