Investing Psychology Chapter 6: Proving Yourself Wrong (Part 2)
Continuing our look at Chapter 6. We know we need to look at the numbers. Now let’s look at the specific mental exercises that can save your portfolio.
Disconfirm, Disconfirm, Disconfirm
The nastiest bias is confirmation bias. We look for news that says we’re smart and ignore news that says we’re wrong.
Tim Richards suggests a simple exercise: imagine your favorite investment has already gone bust. Now, write down exactly how it happened. This forces your brain to look at the risks you’ve been ignoring. If you can’t find a way it could fail, you’re not looking hard enough.
Use a Decision Tree
Instead of saying “this stock will go up,” assign probabilities to different outcomes.
- Company goes bust (1%)
- Company underperforms (20%)
- Company stays flat (30%)
- Company beats the market (49%)
Unless your “beat the market” probability is significantly higher than the alternatives, why take the risk? You can get the market average with a zero-effort index fund.
Expected Value
Don’t just think about the probability of a win; think about the magnitude. A stock that has a 90% chance of gaining 1% but a 10% chance of losing 100% is a terrible bet.
Professional gamblers use “expected value” to make decisions. You should too. If you can’t reduce your “hopes and dreams” to numbers, you’re just gambling, not investing.
The Feedback Loop
Most people hate feedback because it’s painful. We remember our “wins” and delete our “losses” from our memory.
To fix this, you need a diary. Write down why you bought a stock and what you expected to happen. Six months later, check it. Face your errors head-on. Geologists and weather forecasters are good at their jobs because they get constant, unyielding feedback. Investors should be the same.
Living with the “Volcano God”
Uncertainty is the “volcano god” of the market. It strikes without warning and ruins everyone’s day.
We equate “volatility” (the price zig-zagging) with “risk.” They aren’t the same. Volatility is just noise. If your house’s value fluctuated 5% every day on a public website, you’d be a nervous wreck. But because you don’t check it, you stay calm. Do the same with your stocks. Stop checking the price every five minutes.
7 Key Takeaways from Chapter 6
- Numbers beat narratives. Read the balance sheet, not the CEO’s letter.
- Short-sellers are a signal. Use their research to avoid landmines.
- Diversify more than you think. 15 stocks isn’t enough.
- Hunt for disconfirming evidence. Try to prove your own thesis wrong.
- Use decision trees. Think in probabilities, not certainties.
- Calculate expected value. Don’t just chase “big wins” with low odds.
- Demand feedback. Keep a diary and face your mistakes.
In Chapter 7, we’ll build a specific “methodology” for putting all these fixes into action.