Investing Psychology Chapter 2: You're Not as Smart as You Think (Part 1)
We all like to think we’re smart. If we didn’t think we were going to make money, we wouldn’t invest. But here’s a cold splash of water: 93% of American drivers think they’re “above average.” Mathematically, that’s impossible.
In Chapter 2, Tim Richards digs into our egos. It turns out that being a “positive thinker” is great for your mental health, but it’s a disaster for your wealth.
The Introspection Illusion
I have two left feet. I know I can’t dance, so I don’t try. We’re usually good at avoiding things we’re bad at. But in investing, we edit our own lives. We remember the one time we picked a winner and conveniently forget the five times we lost money.
This is the introspection illusion. We think we’re being honest with ourselves, but we’re actually just highlighting our own highlight reel.
The Milgram Experiment and Authority
You might have heard of the Milgram experiment, where people were told to give electric shocks to a stranger. Most people did it just because a guy in a white lab coat told them to.
When asked later, most people say, “I would never do that.” But the data says otherwise. This is blind-spot bias. We think we have the inner strength to resist authority or bias, but we’re just as susceptible as everyone else. In the market, this means we follow “gurus” even when our gut says something is wrong.
Rose-Colored Trading
Brad Barber and Terrance Odean studied thousands of online traders. Their finding? Most traders lose money every time they hit the “trade” button. The stocks they sell usually go up, and the ones they buy usually go down.
Why do they keep doing it? Overconfidence. The more overconfident you are, the more you trade. And the more you trade, the more you hand over to the brokers in fees.
Depressed but Wealthy
There’s a weird phenomenon called depressive realism. It turns out that people who are slightly depressed actually see the world more accurately. They don’t have the “rose-colored glasses” that the rest of us wear.
I’m not saying you should be miserable, but a little bit of healthy skepticism toward your own “brilliant” ideas will go a long way.
Stop Listening to Tips
Alfred Cowles studied “tip sheets” back in the 1930s. He found that forecasters were wrong most of the time. In fact, he joked that the best way to make money was to find the worst forecaster and do the exact opposite.
If you’re getting your stock picks from a “guru” or a magazine, you’re probably the exit liquidity for someone else’s trade.
In the next post, we’ll talk about why we hate losing money so much that we end up losing even more of it.