Investing Psychology Chapter 6: Fighting Your Biases With Better Strategies

Chapter 6 is called “Debiasing.” After five chapters of telling us how broken our brains are, Richards finally starts talking about what we can actually do about it. The short answer: there is no magic fix. But there are tools that help.

Numbers First, Stories Later

The boring truth is that debiasing starts with reading financial statements. Most investors never even open an annual report before buying a stock. Richards says that is a problem.

Here’s the thing about annual reports. They start with a nice narrative from management and end with the actual numbers. That order is not an accident. The narrative is there to spin a story. When the company does well, management says “we did great.” When it does badly, they blame the economy or some external factor. Researchers found that executives even switch from “I” and “we” to third person language when reporting bad results.

The more self-serving the language, the worse the forecasts tend to be. Companies with heavy bias in their reports carry more debt and prefer stock buybacks over dividends. That is a red flag.

So read the numbers. Learn what balance sheets mean. A solid balance sheet is like an emergency fund for a company. Even if you pick stocks badly, firms with strong balance sheets can survive setbacks and still give you decent returns.

Momentum: Going With the Herd

Momentum investing means buying stocks that are going up and selling stocks that are going down. Research showed this strategy gave great returns for periods up to a year. Sounds easy, right?

But here’s the problem. Momentum investing is basically herding with a fancy name. It works until it doesn’t. At market turning points, momentum strategies blow up. And as more people discovered this trick, the edge disappeared. Between 2005 and 2010, momentum strategies actually lost money in U.S. markets.

Any strategy that assumes tomorrow will be the same as today is going to break eventually. Richards calls this the “vanishing anomaly.” Once enough people exploit a pattern, the pattern stops working.

Mean Reversion: The Opposite Bet

If going with the herd is risky, what about going against it? That is the contrarian approach, based on mean reversion. The idea is simple: what goes down must come back up. Buy cheap stocks, sell expensive ones.

Francis Galton discovered mean reversion. He noticed that tall parents tend to have slightly shorter children and short parents tend to have slightly taller children. Things move toward the average over time.

Applied to stocks, this means that overpriced stocks should come down and underpriced stocks should go up. Researchers de Bondt and Thaler showed that investors overreact to recent news. Good news pushes prices too high, bad news pushes them too low. A contrarian strategy of buying losers should work.

But here’s the problem. If everyone knows about mean reversion, they start exploiting it. And then people start blindly selling winners and buying losers without checking if there is a real reason for the price. A company going down might be going down because it is actually failing. Blindly buying it is not contrarian. It is just lazy.

Richards says there is no shortcut. You have to go back to the numbers and figure out if a stock was marked down unfairly. No free lunches.

Short Selling as a Signal

Richards does not want you to short stocks. He is very clear about that. When you buy a stock, the most you can lose is what you paid. When you short, your losses are unlimited. If you short at $100 and the stock goes to $1,000, you lose $900 per share. There is no ceiling.

But short sellers as a group are useful to watch. Because they face unlimited risk, they tend to do their homework much better than regular investors. They dig into the fundamentals. They are less emotional and less biased.

So before you buy a stock, check if it is being heavily shorted. If a lot of smart, risk-aware people are betting against it, there might be something wrong that you are not seeing.

Diversification Is Not “Diworsification”

There is a popular myth that you only need 15 stocks for a diversified portfolio. Richards says this is wrong and dangerous.

Portfolio Theory, invented by Harry Markowitz in the 1950s, is supposed to tell you the optimal mix of stocks. It got popular in the 1970s after years of bad market performance. But it is so complicated that Markowitz himself ignored it when investing his own retirement money.

The 15-stock myth comes from a misunderstanding of the math. William Bernstein showed that 75% of randomly selected 15-stock portfolios from the S&P 500 did not even beat the market. You need 30, 50, or even 100 stocks to properly spread the risk.

And it is not just about the number of stocks. You also need to diversify across sectors and asset classes. Holding 20 tech stocks is not diversification. When the dot-com bubble burst, those portfolios got destroyed. You need different sectors, some bonds, maybe foreign stocks, property.

Diversification is the closest thing to a free lunch in investing. More is better. Lives have been ruined by too little diversification. Never by too much.

Fighting Confirmation Bias

This might be the most important section. Confirmation bias means we look for evidence that supports what we already believe. We ignore anything that contradicts us.

Richards brings up the Wason Rule Discovery Test. You are shown the numbers 2, 4, 6 and asked to guess the rule. Most people guess “goes up by two” and test with sequences like 8, 10, 12. That fits, so they think they are right. But the actual rule is just “any three numbers in ascending order.” People never try a sequence like 5, 17, 843 because they are not trying to prove themselves wrong.

After you buy a stock, you start looking for reasons you were right. You read bulletin boards where other owners are cheerleading the same stock. You avoid negative analysis. This is how people ride stocks all the way down while telling themselves everything is fine.

Richards suggests three techniques. First, imagine your investment has gone to zero. Try to figure out why that could happen. Second, avoid making investment decisions under time pressure. Urgency makes confirmation bias worse. Third, find an investing buddy. One of you argues for buying, the other argues for selling. Force yourself to see both sides.

Decision Trees and Expected Value

Group polarization makes us take extreme positions. The media loves extreme stories. Our brains remember dramatic events. All of this pushes us toward bad decisions.

A simple fix is using decision trees. For any stock, write out the possible outcomes. The company goes bust. It underperforms. It matches the market. It outperforms. It shoots the lights out. Now assign a probability to each one. No zeros allowed.

If the combined probability of above-average outcomes does not beat the rest, do not buy. You can get market-average returns from a cheap index fund without taking single-stock risk.

Richards takes this further with expected value. Say BlueSky Inc. has a 10% chance of doubling but a 50% chance of going to zero. A $1,000 investment has an expected value of $500. Now say OldFirm Inc. has a 5% chance of doubling and a 5% chance of going bust. Same $1,000 investment, expected value is $1,000. The math tells you what your gut will not.

The best investments are companies with a competitive moat, trading at a fair price. Think Coca-Cola. No one can replicate that brand. When companies like that hit trouble and the price drops, that is often the best time to buy. But most people will not buy because the news is scary. That is bias at work.

Richards says you should reevaluate the expected value of every stock you hold at least twice a year, after earnings announcements. Compare your expectations to reality. You will be wrong. But you will be wrong for the right reasons. And slowly, you will get better.

What to Take Away

Chapter 6 Part 1 is about the tools of debiasing. None of them are perfect. Momentum investing looks smart but dies at turning points. Mean reversion sounds logical but gets exploited into uselessness. Even diversification has myths around it.

The real tools are boring: read the numbers, fight confirmation bias, use decision trees, calculate expected value. There is no shortcut. The iron law of the markets is that there are no free lunches.

Next up: Chapter 6 Part 2 - Cognitive Repairs and Satisficing.

Previously: Chapter 5 Part 2 - Corporate Bias and Trading Costs.