Investing Psychology Chapter 2 Part 2: Emotions, Black Swans, and Getting Nudged

In Part 1 we talked about overconfidence, loss aversion, and the disposition effect. Now let’s keep going with the rest of Chapter 2. This part gets into emotions, Black Swans, mental accounting, and some practical ideas on how to not sabotage yourself.

We Love Trusting “Experts”

Here’s the thing about experts. Researcher Philip Tetlock spent years studying how well experts actually predict stuff. Turns out, most of them are slightly worse than the average person on the street. But they will never admit it.

When experts get it wrong, they have three favorite excuses:

1. “I was right, it just hasn’t happened yet.” (Keep predicting a crash long enough and eventually you’ll be right.)
2. “I was right, but something unpredictable happened.” (Life is unpredictable. That’s the whole point.)
3. “I wasn’t wrong.” (And shockingly, most people never bother to check.)

The scariest finding? Research by Radzevick and Moore showed we don’t prefer the most accurate experts. We prefer the most confident ones. The quiet analyst who says “it’s complicated” gets ignored. The loud guy with a bold prediction gets on TV.

Richards calls this overprecision. Detailed, convincing arguments about what will happen. Most of it never comes true. Nobody checks, so they keep doing it.

Lesson 11 from the book: Most experts aren’t any better than us. The ones that are may just be short-term lucky. Never put all of your trust in one person you don’t even know very well.

Emotions Are Baked In

By this point in the book, it’s pretty clear we’re not rational with money. We’re emotional. And Richards digs into why that’s both a feature and a bug.

Psychologist Antonio Damasio studied people with brain damage who don’t feel emotions normally. You’d think they’d be great investors. No panic, no fear-driven selling. And in some ways, yes. They make cold, odds-based decisions without flinching.

But here’s the twist. In Damasio’s Iowa Gambling Task, participants chose cards from four decks. Two were losers, two were winners. Normal people started avoiding the bad decks after only 10 picks, way before they could explain why. Emotions were helping them sense danger. The brain-damaged participants never figured it out.

So emotions protect us in everyday life. But in investing, that same instinct misfires. We see trends in random noise. We panic when markets drop. Which brings us to the big scary bird.

Lesson 12: The best investing is done unemotionally, but not randomly.

Black Swans and Disaster Myopia

Nassim Taleb made the term “Black Swan” famous. All swans are white until you see a black one. Sudden, unexpected events overturn everything we thought we knew.

When Taiwanese researchers re-analyzed the Iowa Gambling Task, the most popular deck was actually a bad one. Lots of small wins, then one massive loss. People loved it because it felt like winning.

That’s basically how stock markets work. Steady small gains, then a sudden crash. Richards quotes the phrase “picking pennies up in front of the steamroller.” Great way to make money until you slip.

Great investors do the opposite. They lose more often than they win, but they cut losses fast and let winners run big. The Babe Ruth effect. Struck out a lot, but when he connected, home runs.

We also have disaster myopia. After a crash, we quickly forget it was even possible. The further we get from the last disaster, the less we think it can happen again. Which is exactly when it does.

Lesson 13: A disaster is always just around the corner. Be prepared.

Mental Accounting: It’s All the Same Money

We do this weird thing where we put money in mental buckets. Holiday fund. Emergency savings. “Play money” for stocks. Each bucket gets its own rules.

In normal life, this is actually good self-control. But in investing, it’s a trap.

Research by Levav and McGraw showed that people tag money with emotions based on how they earned it. Money from questionable sources gets spent on “virtuous” things like education. We’re literally laundering money in our heads.

Here’s where it gets ugly. Combine mental accounting with loss aversion and you get people who sell half their stock when it doubles because they’re “playing with house money.” That’s nonsense. It’s all your money. The stock doesn’t know what you paid for it.

People buy back stocks they sold for a profit, but won’t touch ones they sold at a loss. We fiddle with our mental books to avoid regret. Feels better. Returns get worse.

Lesson 14: Mental accounting is not something investors should do. Don’t split your portfolio into separate buckets. It’s all the same money at the end of the day.

Feel-Good Stocks and Psychophysical Numbing

We tag everything with emotions. Richards calls it the “affect heuristic,” a faint whisper of feeling that guides our decisions below conscious awareness.

If we like something, we judge it as less risky. If we don’t like it, more dangerous. Researcher Yoav Ganzach found that even professional analysts rated unfamiliar stocks based on vibes, not fundamentals. “Buzzy” sectors get high ratings. Unpopular ones get low ratings. And those unpopular sectors often outperform over 3 to 5 years.

Paul Slovic calls it psychophysical numbing. We react to personal stories but go numb with big numbers. One scary anecdote beats statistical evidence every time.

Richards gives the UK MMR vaccine scare as an example. One discredited study scared parents away from vaccinating kids. Statistics showed the vaccine was safe. But stories won. Vaccination rates dropped. Measles came back. Same thing in investing. A friend’s horror story hits harder than a decade of market data.

Lesson 15: Don’t buy stocks just because they’re in a feel-good sector. Humans have emotions, stocks don’t.

Lesson 16: We prefer emotionally charged stories to complex numbers. That’s not a great way to invest.

Martha Stewart’s Portfolio of Biases

During Martha Stewart’s insider trading trial, her portfolio was made public. Researcher Meir Statman analyzed it for behavioral bias. What he found is probably typical of most private investors.

Stewart showed loss aversion (wouldn’t sell losers), regret (wouldn’t sell winners either), the December effect (selling losers only for tax benefits), and scapegoating (stock goes up, my idea; stock goes down, adviser’s fault).

These biases aren’t abstract. They cost real money.

Check Your Portfolio Once a Year. Seriously.

Research by de Bondt and Thaler found that the more often investors look at their portfolio, the more they trade. And the more they trade, the worse they do.

Their suggestion? Don’t check more than once a year.

It sounds painful. But every time you peek, emotions kick in. You see a drop and panic. You see a gain and want to lock it in. The best move is often to just not look.

This is basically why index funds exist. Take the decisions out of your hands. If your self-image is tied to your stock picks, passive investing might be the healthiest choice.

Nudge Theory: Trick Yourself Into Saving

Richard Thaler and Cass Sunstein came up with “nudge theory.” Set up defaults that work in your favor.

Their Save More Tomorrow program is a perfect example. One decision to enroll. Savings automatically increase as salary goes up. Most people never change the default. That’s the whole point. It works especially well with money, because money is where our biases hurt us the most.

The Mindfulness Checklist

Richards ends the chapter with a mindfulness framework borrowed from Catherine Weick’s research on safety-critical organizations like nuclear power plants. Five rules for investors:

1. Be preoccupied with failure. Track your losses honestly. Don’t hide behind mental accounting.
2. Do not simplify interpretations. “Buying on the dips” works until it doesn’t. Question your assumptions.
3. Be sensitive to odd events. Don’t ignore data that contradicts your beliefs. Markets change.
4. Be resilient. Sometimes good decisions still lead to bad outcomes. That’s randomness. Keep going.
5. Don’t get too clever. Too much data leads to information overload. Keep your process simple.

The Seven Key Takeaways of Chapter 2

1. Overconfidence leads to overtrading and more mistakes.
2. We sell winners and keep losers (the disposition effect).
3. Experts are often no better than average. We trust confident ones anyway.
4. Some biases can be managed but never fully removed.
5. We forget past disasters too fast. A crash is always possible.
6. Cold, unemotional investing is ideal but nearly impossible. Mindfulness helps.
7. Sometimes stuff just happens. Accept it and move on.

These biases are normal. The goal isn’t to eliminate them. It’s to stop letting them wreck your portfolio.

Next up: Chapter 3 Part 1 takes us into situational finance, where we look at how the world around us changes the way we make decisions.