Investing Psychology Chapter 2: The Pain of Losing (Part 2)
Picking up from where we left off in Chapter 2. We’ve established that we’re all overconfident. Now let’s look at how that overconfidence turns into specific, expensive mistakes.
Loss Aversion: The Golf Lesson
Professional golfers are better at putting to avoid a bogie (a loss) than they are at putting to make a birdie (a gain). Why? Because the pain of a loss is twice as strong as the joy of a win.
In investing, this is called the disposition effect. We sell our “winners” too early to feel the joy of a win, and we hold onto our “losers” way too long because we can’t stand the pain of admitting we were wrong.
Anchoring to Random Numbers
We love to “anchor” our decisions to the first number we see. In one study, people were asked to write down the last two digits of their Social Security number before bidding on items. People with higher numbers ended up bidding more!
In the market, we anchor to our “buy price.” We think, “I’ll sell as soon as it gets back to what I paid for it.” But the market doesn’t care what you paid. That number is irrelevant. The only thing that matters is what the stock is worth now.
Hindsight is a Liar
“I knew that was going to happen!” No, you didn’t.
Hindsight bias means we rewrite our memories to match what actually happened. We think we’re great at predicting the future because we “predicted” the past so well. This leads to more overconfidence and more bad trades.
The Expert Problem
Philip Tetlock studied thousands of “expert” forecasts. He found that most experts are worse at predicting the future than a monkey throwing darts.
The worst part? We prefer the experts who sound the most confident, even though they’re usually the ones who are most wrong. The person you should actually trust is the one who says, “I’m not sure, the world is complicated.”
Mental Accounting
We treat different “pots” of money differently. We’ll spend a $1,000 tax refund on a vacation, but we’d never take $1,000 out of our savings account for the same thing.
This is mental accounting. In your portfolio, it’s all the same money. Don’t segregate it. A loss in one stock is just as real as a gain in another.
7 Key Takeaways from Chapter 2
- You’re biased toward yourself. Assume you’re overestimating your skills.
- Loss aversion kills returns. Don’t hold losers just to avoid the pain.
- Experts are often wrong. Trust data, not “gurus.”
- Hindsight is a trick. Keep a diary to see what you actually thought.
- Disasters happen. Stop pretending everything is predictable.
- Emotions matter. Use “affect” to sense danger, but use logic to trade.
- Be resilient. You’ll make mistakes. Learn and move on.
In Chapter 3, we’ll look at how the world around us—the situation—changes how we invest.