How “The Law of the Instrument” Punishes Stubborn Investors
When all you have is a hammer, everything looks like a nail.
In this article, we’ll cover the law of the instrument — one of the biggest mental shortfalls in all of investing (and life).
Author’s Note: This article is part of my series on investing psychology:
12 Common Mistakes That Can Destroy Your Investing Profits
Learn how successful investors avoid cognitive traps and build a winning mindset.
The Law of the Instrument — What is it?
The law of the instrument describes an investor’s tendency to overly rely on familiar tools, methods, or strategies while undervaluing other approaches.
This bias is commonly known as, “If all you have is a hammer, everything looks like a nail.”
How does the law of the instrument apply to investing?
It’s human nature to reach for the tools we know best. And in many cases, it’s wise to wield the tool we’re most familiar with.
But when it comes to stock market investing, there’s great risk in becoming overly reliant on a single approach and great opportunity in expanding your skill set.
For example, imagine a value investor who has extensive experience buying deeply undervalued stocks. Sometimes his strategy works incredibly well and sometimes it falls woefully short.
Whenever this value expert comes across new and different investing styles, such as dividend stocks, high quality stocks, and momentum stocks, he scoffs and insists value is always the best strategy.
The problem is that, objectively speaking, value is NOT the best strategy.
Yes, value is a good strategy, with a long history of supporting research. But it’s also known to have very long stretches of underperformance and is therefore an inconsistent strategy.
Plus, there are other strategies that perform just as well as value, and can greatly enhance the power of value investing when combined with value.
But this stubborn value investor continues to hunt only for deeply undervalued companies, ignoring other tools and ideas that could greatly improve his investing profits.
What should you do instead?
One of the most powerful strategies in any area of life, and especially in stock market investing, is to embrace how much you still have left to learn.
The world of investing is constantly changing, with new tools and ideas emerging every year.
Here, I’ll offer one simple piece of advice:
Push yourself to keep learning.
Ask yourself this question:
“Am I always viewing investing through the lens of what I already know? What else can I learn that could grow my investing profits?”
If you’re already great at value investing, spend some time studying momentum investing, which is often viewed as a natural complement to value.
If you focus mostly on large-cap blue-chip stocks, start experimenting with small cap stocks, which have historically offered greater returns than their large counterparts.
To be clear, I’m not suggesting you abandon what you already know. That’s part of what’s made you successful so far!
Instead, look to build on your knowledge by constantly adding new investment ideas, tools, and strategies to your tool box.
Disclaimer: This article is provided for informational or educational purposes only and is not any form of individualized advice. All information is obtained from sources believed to be reliable but cannot be guaranteed for accuracy or completeness. Use this information at your own risk.