In Investing, You May Fall Prey to Inductive Thinking

As the title says, In Investing you may fall prey to inductive thinking. What does this mean to you and how it actually matters to you?

In our efforts to improve your investment skills, this psychology of inductive thinking is very important to understand. You have to protect yourself from being a victim of it.

Before moving ahead, you need to understand what Inductive Thinking is, here is an excerpt from the book The Art of Thinking Clearly by Rolf Dobelli

A farmer feeds a goose. At first, the shy animal is hesitant, wondering ‘What’s going on here? Why is he feeding me?’ This continues for a few more weeks until, eventually, the goose’s scepticism gives away. After a few months, the goose is sure that ‘The farmer has my best interests at heart.’ Each additional day’s feeding confirms this. Fully convinced of the man’s benevolence, the goose is amazed when he takes it out of its enclosure on Christmas Day – and slaughters it. The Christmas goose fell victim to inductive thinking, the inclination to draw universal certainties from individual observations.

Inductive thinking is an inclination towards our recent experiences making us believe that it will happen same in future.

How this affects you as an investor? Here is another excerpt from the book,

An investor buys shares in stock X. The share price rockets, and at first he is wary. ‘Probably a bubble,’ he suspects. As the stock continues to rise, even after months, his apprehension turns into excitement: ‘This stock may never come down’ – especially since every day this is the case. After half a year, he invests his life savings in it, turning a blind eye to the huge cluster risk this poses. Later, the man will pay for his foolish investment. He has fallen hook, line, and sinker for induction.

Inductive Thinking & Mutual Fund Investors

Now, how does this affect mutual fund investors? Well, most of the investors of equity mutual funds do take the opposite actions, which means that they should invest more when markets fall and decrease equity allocation when markets get overvalued.

But what is being done? Let’s go back a few months when the corona pandemic started, Markets started falling, from 42,000 SENSEX to 40,000 then 37,000 then 35,000 – Investors who fall prey to induction thinking started thinking that market could fall more, then markets nose-dived to 30,000 and then 26,000 here investors got panic and started thinking everything is finished, complete lockdown, no business, markets will fall to 10,000 or even lower – everything is finished!

Here inductive thinking was playing its role and investors those fell prey to it, decided to redeem at losses, and went home.

What happened next? Markets did opposite, it started recovery from 26,000 to 29,000 then 32,000 then further to 37,000 and now at new highs at 43,000 many investors who exited at 26,000 are now planning to enter again with the feeling that market will continue rising further like this and soon touch 60,000 or more.

Well, markets never move in a single direction always, neither downside nor upside, markets are meant to grow more in long run but in the short-run corrections do happen, sometimes small sometimes big.

Investors who invest more when markets fall enjoys the real benefit of wealth creation, others fall prey to inductive thinking and lose wealth.

It makes no sense for these investors coming back at 40,000 or 43,000. You must not fall prey to inductive thinking like these investors, instead, become smart by following a proper asset allocation strategy and review them regularly.

If you want to understand more about how the asset allocation strategy works in mutual funds, you can click here to schedule your appointment with me – It’s Free!

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