The Five Neglects

Reflections #1

Welcome to this week's edition of Reflections. In this issue, we dive into the concept of The Five Neglects and how these overlooked biases can influence your investment decisions. We'll explore the subtle ways our minds can lead us astray, and more importantly, how you can take control to make smarter, more informed choices.

Why care?

Investing is as much about managing psychology as it is about managing money. Among the various cognitive biases and traps investors face, The Five Neglects stand out as particularly dangerous. These mental oversights can cause investors to misjudge risks, overlook critical details, and ultimately, make suboptimal decisions. Understanding these neglects can help you navigate the complexities of the market with greater clarity and confidence.

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1. Probability Neglect: Chasing Unlikely Gains

Investors often fixate on the potential rewards of an investment without adequately considering the likelihood of those rewards materialising. This is probability neglect. For example, you might be tempted by the allure of high returns from speculative stocks, but fail to assess the real probability of achieving those returns. The excitement of a big payoff can cloud your judgment, leading to risky bets that don’t align with your long-term goals.

Action Step: Always evaluate the probabilities, not just the potential returns. Ask yourself, "What are the realistic chances of this outcome?" Let that guide your investment decisions, rather than the allure of outsized gains.

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2. Consequence Neglect: Overlooking the Downside

While probability neglect focuses on ignoring the likelihood of outcomes, consequence neglect involves ignoring the potential impact of those outcomes—especially negative ones. In investing, this often happens with tail risks, where low-probability events (like market crashes) could have catastrophic consequences on your portfolio. Many investors neglect to consider these risks because they seem unlikely, but ignoring them can lead to severe financial damage.

Action Step: Balance the probabilities with the potential consequences. Even if an event is unlikely, if the downside is severe, take steps to protect your investments, such as diversifying your portfolio or using hedging strategies.

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3. Statistical Neglect: Misinterpreting Market Data

Investors are bombarded with data, from earnings reports to economic indicators. However, our brains aren't always equipped to process this information accurately. Statistical neglect occurs when we rely on mental shortcuts instead of rigorous analysis. For instance, the availability heuristic might lead you to overestimate the likelihood of a market downturn after reading a series of negative headlines, even if the broader data suggests otherwise.

Consider This: Take the time to thoroughly analyse the data, and be mindful of filtering out the noise. Avoid drawing conclusions based on limited information or recent trends. Instead, focus on the broader context and long-term patterns. By cutting through the daily chatter, you can make decisions based on sound analysis rather than reactive impulses.

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4. Solution Neglect: Sticking to What You Know

In investing, solution neglect occurs when we default to familiar strategies and fail to explore potential alternatives that might enhance our approach. This often stems from the comfort of the status quo, the perceived complexity of new options, or a reluctance to challenge long-standing practices. While it's crucial to stay within your circle of competence, it's equally important not to let that circle become a constraint. Over time, this can lead to missed opportunities and a lack of diversification in your investment strategy.

Consider This: Regularly assess whether your investment strategies still serve your evolving goals. Expanding your circle of competence doesn't mean abandoning what you know; it means thoughtfully exploring new ideas and approaches that align with your financial objectives. Growth in investing comes from both deepening your knowledge and being open to learning about new opportunities.

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External Risk Neglect: Overlooking Broader Impacts

External risk neglect occurs when investors focus solely on their immediate returns without considering the broader risks that could impact their portfolio. This could involve ignoring potential macroeconomic shifts, technological disruptions, geopolitical events, or regulatory changes that, while not immediately apparent, could have long-term effects on your investments. For example, an over-reliance on a single sector or region could leave your portfolio vulnerable to industry-specific downturns or regional instabilities.

Consider This: Take a holistic view of your investments by factoring in a wide range of external risks. Consider how the events discussed earlier might impact your portfolio over time. By thinking beyond immediate returns, you can better prepare for potential challenges and seize opportunities that align with a well-rounded investment strategy.

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Conclusion: Invest with Awareness

By recognizing The Five Neglects—probability, consequence, statistical, solution, and external risk neglect—you can avoid common pitfalls that trap many investors. The next time you evaluate an investment, pause and ask yourself if you’re considering all the relevant factors. Are you balancing probability with consequence? Are you analysing the right data and thoroughly? Are you open to new strategies and mindful of external risks?

With mindfulness and a systematic approach, you can make smarter investment choices that help secure your financial future. Curious about how we do this? Explore our investing philosophy below.

Our Investing Philosophy [Free Checklist]

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Disclaimer: The content provided in this newsletter is for informational purposes only and does not constitute financial, investment, or other professional advice. The opinions expressed here are those of the author and do not necessarily reflect the views of Schwar Capital. Investing involves risk, including the possible loss of principal. Past performance is not indicative of future results. The author may or may not hold positions in the stocks or other financial instruments mentioned. Always do your own research or consult with a qualified financial advisor before making any investment decisions.