I’ve seen people do painfully stupid things in my career that cost them their entire life savings. In this article, you will learn about 5 examples of fallacies in business that pave the path to bankruptcy.
I was a financial advisor for several years. It was a common way for business school graduates to get their first job. Overall, it was a good experience, but I was always in a moral bind.
It was a job based on commission, so logical fallacies were often used to attract new investors or generate more business. There was only one good thing about seeing these flaws in reasoning twist reality and get people to make bad choices: to learn.
I learned enough about it so that I won’t be fooled again. I know enough about it to help you avoid falling into the same trap.
Here are examples of logical fallacies in business and investments that can break you — but they are also easily avoidable if you KNOW about them.
The Most Used of all: The Confirmation Bias
I started with this since it’s the one that financial advisers see (and often use, unfortunately) the most frequently.
In addition to this, it is the most common though it is the most ridiculous.
The propensity of the human brain to remember our little successes and forget our minor defeats is known as confirmation bias. It serves as a kind of self-defense mechanism for our ego. The issue is that it frequently spirals out of control and overestimates both our wins and the likelihood that we will win again.
An investor from our brokerage firm once purchased a penny stock with the symbol KELP3 (I slightly changed the code to preserve the privacy of the entire situation). Each stock was only 18 cents back then, so even a small change might make or destroy a portfolio.
This investor made about 20% in profit from his first investment, and a lower but still sizable return from his second. The problem was that he thought of himself as an authority on stock movements following these two fortunate shots. The stock moves, however, were — you guessed it — inexplicable. By the time I left the firm, he had lost a lot of his gains and was still insistent on swing trading KELP3.
When someone claims to “be familiar” with a stock’s movements, the confirmation bias is nearly always present. The individual is just DELUDED.
Being “acquainted” with random asset fluctuations is clearly ludicrous to anyone who knows something about biases and logical fallacies in business. It sounds as silly as someone claiming to be an experienced dice thrower.
The one fallacy that caused the biggest money loss I ever saw: The Green Lumber Fallacy
The term “Green Lumber Fallacy” comes from a story Nassim Nicholas Taleb tells in his book “Antifragile.”
Joe Siegel, one of the most successful traders in a commodity called “green lumber,” actually thought that it was lumber painted green (rather than freshly cut lumber, called green because it had not been dried). And he made it his profession to trade the stuff! […] This gets at the idea that a supposed understanding of an investment rationale, a narrative or a theoretical model is unhelpful in practical trading.
In the financial institution I worked for, I often witnessed similar occurrences. It happens when you erroneously believe that a certain talent or set of information will assist you make a business decision when, in fact, it won’t.
In the financial institution I worked for, I often witnessed similar occurrences. It happens when you erroneously believe that a certain talent or set of information will assist you make a business decision when, in fact, it won’t.
The most surprising time I saw this fallacy in action was when I worked with a broker named Lucca. He came from a well-known and influential family of South American coffee producers. Coffee futures were one of the most popular derivatives in our operations room.
Lucca then came to our morning brief and proclaimed that he had some very useful information. He told us that the neighbour of his cousin’s uncle told him that coffee harvests were getting smaller because it hadn’t rained enough, so prices should go up in the future.
And he bet heavily (on multiple occasions) on his “assured” premises based on the farming knowledge of his family. But coffee futures are not exactly coffee beans.
I’ve never seen somebody lose as much money trading coffee futures as he did.
Check also: 5 Countries Benefiting From the War in Ukraine and Crises of 2022
Survivorship Bias: One of the fallacies in business where we erase the past.
Our office sometimes set up network meetings of our clients.
There, they put together successful investors with a lot of experience and people who want to do business with them. Needless to say, when the potential investors heard about the profits and successes of the more experienced investors, they got very excited. If someone took the average of all their returns, it would be a lot more than the index.
So, for those prospects, it seemed possible and even easy to get returns that were higher than the market average. The problem is that the investors in the room were only those who had been able to remain alive””. In our room, there were no broken speculators or swing traders who were close to going bankrupt.
By only talking to the ones who made it, the would-be investors didn’t know the stories of those who didn’t make it. This bias is most common in investment courses, webinars, and consulting services. They often use it as a way to sell things by saying “Check out our success stories.” No one gives examples of those who failed.
Read also: How a Hedge Fund Pulverized 87% Of Investors’ Equity — An Alert For You
The Sunk Cost Fallacy
Back in the operations office, we called this logical bias the “deluded loser bad decision.”
This is probably the most common mistake that new investors make, and it’s sad to see what happens when they do.
Most of the time, this happens when an investment portfolio loses a substantial amount of value. The investor thinks that it doesn’t make sense to “get out now” if he has already lost 20% or 30%.
This line of thought doesn’t make sense on its own. It would help if he knew the asset would have a reversion and increase in value. But it makes no sense to say that your portfolio is already down X%, so you should do nothing. Unless X is 100%, in which case you can no longer do anything.
Other more practical examples of sunk cost fallacies:
- Keep reading a boring book because you already took it from the library and only will give it back next week.
- Keep watching a bad movie all the way through because you already paid for the cinema tickets.
- Keeping an incompetent worker instead of firing him/her because the company has already spent too much on training.
If you enjoyed this article about examples of fallacies in business, below are some pieces that will be really helpful to you for the next few months (and likely the entire 2023):
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- Deep Work vs Shallow Work: A Crucial Step for a Productive Ogre
- Here is a practical guide to surviving the mega inflationary wave, with advice from Argentinians, Brazilians, Poles, and others who have experienced life under out-of-control inflation firsthand.
Good luck, and good reading.
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Levi Borba is the founder of expatriateconsultancy.com, Small Business Hacks, creator of the channel The Expat, and best-selling author.