Investing Psychology Chapter 1: How Your Brain Tricks You About Money

Previous: Intro post

Chapter 1 of Investing Psychology is called “Sensory Finance.” And it starts with a punch to the ego.

Tim Richards compares walking through an investor’s mind to a tourist bus ride through Wonderland. What feels obviously true turns out to be false. What looks like nonsense is actually closer to reality. Our senses keep us alive, sure. But they won’t make us rich.

You’re Not Special (The Bias Blind Spot)

Here’s the thing. Most people happily agree that others are biased. But then they argue that they personally are different. That they can see through the fog better than everyone else.

Richards demonstrates this with the Muller-Lyer illusion. Two lines with arrows on the ends. Same length. But your brain refuses to see it that way. Even after you measure them with a ruler, they still look different.

Why? Our brains evolved to process 3D environments, not trick drawings. The same brain that kept our ancestors alive near woolly mammoths now fails at processing financial information. Your eyes even have a literal blind spot where the optic nerve enters. Your brain fills in the gap with a guess. You never notice.

Psychologists call this the “bias blind spot.” You’ll agree everyone else has biases but insist you’re different. You can’t introspect your way out of it. Nobody can. Lesson 1: don’t think you’re immune. You’re not that special. None of us are.

Seeing Patterns That Don’t Exist

We navigate life by spotting patterns. Cars drive on the right. White coats in hospitals mean doctors. These shortcuts work most of the time. But in investing, they can destroy your money.

Richards calls it pareidolia. Seeing patterns in random stuff. Like the Man in the Moon. Or religious figures in bakery products. We do the same thing with stock charts. We stare at graphs and see trends that aren’t there. We compare current conditions to some past period and think we’ve cracked the code.

Research by Whitson and Galinsky showed something scary. When people feel out of control, they’re more likely to see fake patterns, create conspiracy theories, and believe superstitions can change outcomes. This was true for expert investors too. The very times when markets crash and you most need to stay calm are exactly when your brain starts inventing patterns.

Superstitious Pigeons and Superstitious Investors

Here’s one of my favorite parts. B.F. Skinner put hungry pigeons in cages and gave them food at random intervals. The birds connected whatever they were doing when food appeared to the food itself. Head bobbing. Spinning. They developed superstitions.

And when the food came only sometimes after their “ritual,” the superstition got stronger. One pigeon repeated its hopping over 10,000 times after reinforcement stopped. Inconsistency made them try harder, not give up.

Now think about stock markets. If there’s one environment built for intermittent reinforcement, it’s financial markets. Wait long enough and anything will happen. So if you develop a pet theory about when to buy or sell, and it works once in a while, you’ll keep at it even when it’s losing you money. Just like Skinner’s pigeons.

Research on 401(k) investors confirms this. People whose plans had high returns invested more. High volatility made others invest less. Basic reinforcement learning. But past performance doesn’t predict future results. Studies by Glaser and Weber found most inexperienced investors don’t even know if they’re making money.

Lesson 3: track your actual returns. Don’t rely on your gut. Otherwise you’ll keep repeating mistakes like Skinner’s pigeons.

The Super Bowl Effect (If It Looks Too Good to Be True…)

The Super Bowl effect says the conference of the winner predicts stock market direction for the year. NFC wins, markets go up. AFC wins, markets go down. Completely insane idea. And it worked 28 out of 31 years between 1967 and 1997.

But flip it. Does the stock market predict the Super Bowl winner? Of course not. The game is decided on the field. So why would the reverse be true?

Richards uses this to make a bigger point: be suspicious of simple explanations for complicated things. Markets are influenced by politics, economics, psychology, demographics, and a thousand other factors. And this applies to Bernie Madoff types too. Returns that are too good to be true? They are. Many intelligent people handed over their savings because they wanted to believe. If it looks too good to be true, it is.

Your Financial Horoscope

Richards compares stock market forecasts to horoscopes. Harsh, but he backs it up.

In 1949, psychologist Bertram Forer gave every student the exact same “personalized” horoscope. Most said it described them accurately. Statements like “you have unused potential” and “you’re sometimes extroverted, sometimes introverted.” Vague enough to fit anyone. This is the Barnum effect, named after P.T. Barnum who said “we’ve got something for everyone.”

Now replace “horoscope” with “stock market analysis.” Same trick. Vague enough to sound right. We look for evidence confirming what we already believe and ignore the rest.

Lesson 5: be wary of anyone who confidently predicts market movements. They’re exploiting the Barnum effect, or worse, they believe their own stuff.

Uncertainty and the Unknown Unknowns

Markets are unpredictable. Richards borrows Donald Rumsfeld’s phrase: “unknown unknowns.” The things we don’t know we don’t know.

Here’s what most people miss: uncertainty is always there. When your job is safe and the mortgage is getting paid, you just stop noticing. The unknown unknowns didn’t go away. You got comfortable.

When uncertainty becomes obvious and markets crash, our brains go into overdrive creating fake patterns. We try to turn unknowns into something we can predict.

The best investors on Wall Street? They sit on their hands during volatile conditions. Sometimes doing nothing is exactly the right move.

The Illusion of Control

We need to feel in control. It’s hardwired. Studies showed that giving elderly people even tiny amounts of control, like a plant to care for, actually increased their life expectancy. Wanting control is human.

But in investing, it’s dangerous. In a coin toss experiment by Ellen Langer, people who got early positive feedback believed they had skill at predicting flips. Sound familiar? Some investors get lucky early and think they’re “naturally good” at picking stocks.

A study of professional traders in random market conditions found that traders with the strongest illusion of control performed the worst. They saw successes as proof of skill and took bigger risks. The more deluded, the more money lost.

If you think you can predict short-term market movements, you’re wrong. And if your adviser claims they can, find a new adviser.

Stocks Aren’t Snakes

When things get really uncertain, our brains switch to survival mode. Fight or flight. React fast.

Richards points out this makes sense for actual snakes. Better to jump away from 99 sticks and 1 real snake than calmly analyze each one. But stocks aren’t snakes. You can get bitten by bad investments many times and still recover. It is almost never necessary to react quickly in markets.

Salespeople create urgency on purpose. “Act now.” When someone pressures you to make a fast financial decision, that’s a red flag, not a reason to hurry. Slow down, let your logical brain take over. Any investment decision that can’t be slept on should be ignored. Any adviser who pushes quick decisions should be fired.

Key Takeaways from Chapter 1

1. Bias blind spot - You’re just as biased as everyone else. Accept it.
2. Illusory pattern recognition - Your personal experiences are not a reliable guide to stock market trends.
3. Investment superstitions - Track your actual returns. Don’t be a pigeon.
4. Super Bowl effect - Simple explanations for complex markets are almost always wrong.
5. Barnum effect - Market forecasts are financial horoscopes. Stay skeptical.
6. Uncertainty - Unknown unknowns are always there. Sometimes doing nothing is best.
7. Illusion of control - Feeling confident doesn’t mean you’re right.
8. Stocks aren’t snakes - Never rush a financial decision. Slow down.

This chapter is basically a warning label for your brain. It’s built for survival, not investing. And the sooner you accept that, the better your money decisions will be.

Next up: Chapter 1 Part 2 - Herding and Mental Shortcuts