Investing Psychology Chapter 2: Overconfidence, Loss Aversion, and Your Ego

Chapter 2 of Tim Richards’ book is called “Self-Image and Self-Worth.” And the title tells you everything. This chapter is about how your ego quietly destroys your investment returns.

We already know from Chapter 1 that our senses trick us. But here’s the problem: we think we’re smart enough to deal with it. We think we’re better than average. Spoiler: we’re probably not.

The Introspection Illusion

Think about what you’re good at. Go ahead, make a mental list. Now think about what you’re bad at. Chances are, the second list is way shorter. And you probably don’t care about the stuff on it.

That’s because we all edit our own lives. We spend most of our time doing things we’re at least okay at. We avoid the stuff we suck at. So when we look back at our experiences, most of them are positive. And we start thinking we’re above average at… well, everything.

Richards calls this the introspection illusion. We don’t realize that our positive self-image comes from carefully avoiding situations where we’d fail. We remember our wins. We conveniently forget our losses. And then we walk into the stock market thinking we’re going to crush it.

In its worst form, this becomes self-serving bias. When things go well, it’s because of our skill. When things go bad, it’s because of external factors we couldn’t control. Sound familiar?

Lesson from the book: Positive thinking is not a positive thing for an investor. Save the optimism for other areas of your life. When it comes to money, deal with reality.

Blind Spot Bias (Again)

Remember blind spot bias from Chapter 1? The idea that we think everyone else is biased, but not us? Richards says it’s a direct side effect of the introspection illusion.

Here’s a fun fact. Researcher Ola Svenson showed that 93% of American drivers think they’re better than average. That’s mathematically impossible. But we all believe it about ourselves.

Richards brings up the famous Milgram experiment here. Participants applied electric shocks to another person just because someone in a white coat told them to. When asked, almost everyone says they’d refuse to do that. But the research says most of us would comply. We just can’t see our own weaknesses.

Lesson from the book: Blind spot bias affects everyone. You can’t avoid it, but you can recognize it. Good investors stay humble.

Overconfidence and Rose-Colored Investing

The introspection illusion makes us overoptimistic. And overoptimism leads straight to overconfidence. This is especially dangerous in investing, where feedback is slow and unclear.

Brad Barber and Terrance Odean studied internet traders and found something painful. Most traders lost money every time they traded. The stocks they sold went up. The stocks they bought went down. And they paid brokerage fees for the privilege. Another study by Glaser and Weber found that the more overconfident an investor, the more they trade. That’s like the worst drivers spending the most time on the road.

This isn’t new. As far back as 1915, stockbroker Dan Guyon showed people lost money even while stocks rose 65%. A Dalbar study found active investors made only a fifth of what they could have earned by just buying an index fund and going on vacation.

Lesson from the book: Overconfidence is deadly for returns. Trade rarely. Only act when the evidence is strong. Otherwise, do nothing.

Depressed But Wealthy

Here’s a weird one. Research shows that depressed people are actually better investors. It’s called the depressive realism effect. When you’re depressed, you see the world as it actually is, without the rose-colored filter.

Nobody is saying “get depressed to get rich.” But it proves the point: our brains are wired for optimism. Great for survival. Terrible for stock picking.

The good news? Experience helps a bit. A study by Meyer, Koestner, and Hackethal showed experienced investors trade less over time. Reality slowly creeps in.

Lesson from the book: Don’t risk too much early in your investing career. If you’re naturally optimistic, be extra careful with your money.

The Disposition Effect and Loss Aversion

Now we get to one of the biggest problems in investing. We sell our winners too fast and hold our losers too long. This is called the disposition effect.

Why? Because selling a winner feels good. It locks in the “win.” And holding a loser lets us pretend the loss isn’t real. As long as we haven’t sold, we haven’t “really” lost money. Right?

Wrong. This is loss aversion at work. We hate losing so much that we’ll do irrational things to avoid it.

Richards uses a great example from golf. Researchers Pope and Schweitzer found that pro golfers try much harder on putts to avoid a bogey (a loss) than on putts for a birdie (a gain). The pain of losing beats the joy of winning. Even for pros.

The same pattern shows up in professional investors. They hold losing stocks longer and own more losers than winners. We all hate taking losses, so we hang on to bad stocks hoping they’ll come back.

Lesson from the book: Treat every investment decision on its own merits. A loss on paper is still a real loss. Value matters more than your feelings.

Anchoring

Why do we cling to losing stocks? Partly because of something called anchoring. We attach ourselves to the price we paid. That number becomes our reference point for success or failure.

But think about it. The price you bought at is basically a random point in time. It shouldn’t matter more than any other price. What matters is whether the company is still worth owning at the current price.

Dan Ariely ran a neat experiment. He asked people to write down the last two digits of their Social Security number, then bid on items. People with higher numbers bid more. A totally random number influenced what they were willing to pay.

Same thing in real estate. People anchor on peak prices and refuse to sell for less, even though everything around them is also cheaper.

Lesson from the book: Your buying price is just a random point on a chart. Don’t let it control your decisions. Trade based on current value, not historical anchors.

Hindsight Bias

Last one for this section, and it might be the sneakiest. Hindsight bias means we think we predicted the present. But we didn’t. We just edited our memories to make it seem that way.

Researcher Baruch Fischhoff showed that people change their memories after learning what actually happened. Even the CIA considers hindsight bias “ineradicable.”

Goetzmann and Peles asked investors to recall their returns. They overestimated by more than 5%. Their memories literally told them they did better than they actually did. This feeds overconfidence. If you “remember” predicting the market right, you’ll think you can do it again.

Lesson from the book: Keep an investing diary. Write down when you buy, why you buy, and what happens. You cannot trust your memory. It’s not built for accuracy. It’s built for survival.

What to Take Away

Your ego is the enemy of good investing. Introspection illusion leads to blind spot bias, which leads to overconfidence, which leads to the disposition effect, loss aversion, and anchoring. Hindsight bias makes sure we never learn from our mistakes.

Richards is not saying you’re stupid. Your brain evolved for survival, not for picking stocks. Recognizing that is step one. The practical stuff: trade less, track results honestly, don’t follow gurus, leave your ego at the door.

Next up: Chapter 2 Part 2 - Emotions, Black Swans, and More Biases.

Previously: Chapter 1 Part 2 - Herding and Mental Shortcuts.