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I can save you a lot of time. When you apply humans to a complex process and expect predictable results... you won't get them. Psychology can turn the investment landscape into a minefield.
When I was heading to work last week, my son said, "Watch the outcome bias." I'm not sure outcome bias was the first thing on my mind when I was a junior in high school, but I assured him it was now front and center. Outcome bias leads you to evaluate the quality of your decisions based on how things turned out, rather than their reasonableness at the time they were made. It's particularly dangerous in investing. For example, if you bought Nvidia 30 years ago when its primary market was selling to teenage boys who spent more time researching gaming accelerators than showering, today you would be happy. This despite the risk you absorbed: Nvidia almost went bankrupt three times in the 1990s, coming within 30 days of missing payroll in one particularly harrowing incident.
The problem with outcome bias is that it leads you to formulate your next investment decision based on tenuous reasoning. Perhaps it was just luck that your outcome ended up as it did, whether good or bad.
A second psychological tendency that afflicts investors is over-weighting errors of commission relative to errors of omission. For example, one year ago had you committed to an investment in Charter Communications, today it would be down about 65%. You would have felt bad as you watched your investment dwindle, and refreshing the web page several hundred times did not make the investment rise. You perhaps didn't think much about buying Micron stock, but you could have; it was omitted from your range of actions. And a year later Micron would have delivered 10X your money. The opportunity cost of not buying Micron was higher than the cost of the Charter loss, but it doesn't feel that way.
If you are a reflective person, avoiding errors of omission can drive you borderline crazy and lead to decision paralysis. So many things start to look like an error of omission that the constant comparison itself becomes a problem.
If you somehow controlled these and other psychological investing hurdles, that wouldn't fully resolve the issue, because everyone else also faces them. And that means others are going to swing markets in ways that are unpredictable, and which will affect you. This is a reason many professional investors have struggled the past two decades in the markets: decisions often are not based on balance sheets or securities analysis. Much buying and selling is based on what your neighbor--the one who leaves his trash can on the street for too many days but otherwise has some great stock tips--thinks.
As an investor, you want to control for these psychologies, but assume they'll continue to exist elsewhere.
~Dan Cunningham
1. More from Science Direct on outcome bias
2. Charter, Micron stock values: 5/26/25 - 5/29/26, YCharts
2026 has begun with an asset class performance reversal in the United States. Small capitalization stocks, which lagged their larger-cap peers last year, have come out of the gate roaring ahead.1 There are several reasons for this shift. One is valuation: traditional investment theory suggests that valuations tend to revert toward a mean over time, and asset classes had become somewhat stretched relative to one another.
Another factor is interest rates. Small caps tend to benefit from the prospect of lower rates, and markets appear to expect that may be coming. Smaller companies generally carry more debt, and that debt is often shorter in duration.2
Consider a hypothetical example. Imagine you are an investment banker, and Apple Inc. (large cap) and Crocs Inc. (small cap) approach you to raise debt capital.
Crocs may say, "Look, contrary to your sartorial instincts, we are quite fashionable. And we designed this new texture on the bottom of the sandal that kind of massages your foot as you walk. We think people are going to love it!" You may think "My feet are tingling, but that's not much of a competitive advantage. I could take a little chisel and change the sandal mold myself fairly easily."
Then it's Apple's turn. There's a little swagger in their pitch because they are Apple. Maybe they say "Ok, it's true we’ve stumbled with Siri for three consecutive years. And our text autocorrect has probably broken up a few marriages. But have the customers left? No. They're deeply embedded in our ecosystem. And if needed, and we will hire our biggest competitor, Google, to help improve it." You think, "That's a very durable protective moat and large competitive advantage."
Under this scenario, Apple secures the long-duration, low-cost debt financing. And Crocs doesn't. But in theory, it means that when rates come down, Crocs, and small caps, will benefit more. As interest expenses fall for companies like Crocs, profitability improves, and markets often respond positively.
Moving beyond the hypothetical, I want to clear up a little definitional confusion about indexes, index funds, mutual funds, and ETFs.
An index is simply a defined collection of securities that you are going to invest in. It’s essentially a rules-based list. Constructing that list is harder than it sounds. Most large fund companies, such as State Street, BlackRock, or Vanguard, license these lists from index providers. As an example, the S&P 500 is created and maintained by Standard & Poor’s, an index provider.
Once the fund companies have the license, they then build funds that we can invest in for you. These generally take the form of either mutual funds or ETFs. Each form has advantages and disadvantages. But we almost always will use an ETF for liquidity and tax efficiency reasons.
Importantly, the ETF or mutual fund is simply the wrapper — the basket that holds the underlying securities defined by the index.
~Dan Cunningham
1. Small vs large-cap performance: Stockcharts.com
2. More technical discussion if you are interested:
Debt exposure is quite different between small and large caps. Net Debt to EBITDA is 3x for small cap vs large cap. (Source: State Street 7/18/25). Floating rate debt of the Russell 2000 is more than 5x the S&P 500 (Source: Goldman Sachs 11/4/25). Constituents of the Russell 2000 had weighted average debt maturity of 4.8 years versus 8.8 for large companies as of late 2022 (Source: Boyar Research Q3 2023 letter), meaning they have to refinance sooner into higher rates, or pay off debt sooner.
One of the things you see around the New Year, and it seems to happen every year, is a group of analysts saying "This year is going to be a stock picker's market." I've never been able to figure out what this means. I think they mean that there might be a divergence in winners and losers in the coming year. But if this is the case, why not buy the index and own all the positions, because you don't want to risk picking the loser? If there is not a divergence in winners and losers, what's the point of picking anything? If they all do about the same, why not just own the index?
Picking stocks can be fun, and if you do it, I suggest you keep the amounts small and limit yourself to, say, 3 trades per year.
It's only January and I don't want to rain on the stock pickers' parade yet, because they’re probably already feeling a little grumpy with Dry January dragging on and all the online sites telling them how great they’re supposed to feel with that, but I feel compelled to. Let's look at an issue in picking stocks, specifically in a taxable account, that's not talked about a lot. That issue is private equity, and there is a lot of it in this era. Private equity folks prowl around the markets, looking for firms they can take private. Sometimes the companies they buy are in tough shape, and they need new management teams, the corporate jet fleet has to get sold, etc. But in other cases the private investors see a great company and they believe it is better than the markets appreciate.
So you and private equity agree, this firm rocks, let's ride it to the moon. Except then private equity embraces the adjective in their name, and they proceed to take the firm private. Your romance with them ends as you realize that not only do you not get your moonshot, you get a significant tax bill handed to you as you are forced to recognize your existing capital gains, giving your returns a haircut.
Ok, say you get lucky and the founder of the firm is still in control, and she listens to the "go private" pitch from private equity and says "No, actually I like being sued by endless plaintiffs' attorneys every time our stock drops a little. That's fun for me and I'm going to stay public." And the private equity guys get ushered out of the conference room dejected but they are all thinking "Wow that was pure steel" and they're all buying her shares for their personal accounts on their iPhones as they enter the elevator.
So the stock keeps running up, but the problem is all good things come to an end. Today, half of all of the companies that were in the S&P a decade ago are no longer in it (though this includes buyouts).1 Eventually the business and the stock plateau, and now, as a shareholder, you're kind of stuck. It's tough to get out of the position because of the taxable gain. But you don't really want to be in it either. Note that real estate and other asset purchases have the same problem.
Index funds are so good at saying "I told you so" that it almost gets annoying over time. But here again the index says "Guess what, using some fancy financial technology, we swapped that mediocre firm without creating a taxable gain and added in a new firm with better prospects." And then if done correctly, One Day In July can manage the rebalancing system among indexes without ever recognizing gains. This can get a bit tricky, but the objective is that both within and among the indexes, no recognized capital gains are created, even over long periods of time.
So in addition to protecting you from the "stall out problem" of an investment, the indexing strategy helps minimize taxes. Indexing should get a seat at the table, perhaps the head seat, in any tax planning strategy discussion.
~Dan Cunningham
1. Innosight Corporate Longevity Report. https://www.innosight.com/insight/creative-destruction/
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