The Psychology of Investing

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Warren Buffet, the world richest investor, says that once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.

There’s an old rule in investing that sums how you can win in the stock market, which is “buy low, sell high”, though it sounds simple, most people do the exact opposite. People tend to sell during panics as fear controls them and buy when the market is going up as greed takes control. This irrationality is not a beginner mistake but a fundamental flaw in our thinking, whether you’re a beginner or an expert.

Why do we make irrational decisions?

Psychologists and cognitive scientists found that we have two systems of thinking

  1. Fast System
  2. Slow system 

The fast system is our default, it’s how we make 95% of our decisions, it’s sometimes irrational, biased and mostly wrong. The slow system is logical, more comprehensive but rarely used in our daily life.

Want to know more about which system you’re using now ? Consider answering this question: 

A baseball and bat cost EGP 110. The bat costs EGP 100 more than the baseball, how much does the ball cost? 
If your answer was EGP 10, then you used the irrational fast system of thinking. The right answer is EGP 5. If you got the wrong answer, don’t worry you are not alone. 50% of Harvard, Princeton & MIT students (who were asked that question) got the wrong answer too.

The correct answer is X + (X + 100) = 110, solve for x

Our fast system tends to draw conclusions fast without comprehending the facts. So let’s look at some of the major biases and traps that lead us to make bad decisions.

Loss aversion 

“If we could be freed from our aversion to loss, our whole outlook on risk would change”

We tend to fear loss more than we desire gain. Research shows that fear is twice strong as greed. This bias seems logical to some extent, but it creates a flaw in our risk taking decisions. Consider the following scenarios:

You can win EGP 900 for sure (100% probability), or to win $1000 at 90% probability, so there’s a 10% probability that you’ll end up with nothing. Which one will you choose?

If you’re like most people, you’d go with the safer road and take the $900.

Let’s go for a different scenario, you can lose $900 for sure or to lose $1000 at 90% probability, so there’s a 10% probability that you’ll lose nothing at all.

Most people tend to take the risk here. They don’t want the certain loss, so they take risk so they can avoid the loss even if it’s just a 10% chance.

If we are totally rational species, then our choice in both scenarios should be the same, whether to take the risk or be conservative. But our flawed thinking and loss aversion tendency make us take risks only when it comes to avoiding losses not achieving gains. 

Empathy Gap

“Be fearful when others are greedy, be greedy when others are fearful”

We turn out to be very bad at predicting how we will act in the future. We think that we can commit to a restricted diet after eating a large meal, however we overeat again once we become hungry. This inability to predict our own future behavior is called “empathy gap”. In a cold state, we think we can commit to our rational plan, but once we are in an hot state (emotional pressure), we give up the plan easily. That’s why you should never go to the supermarket when you are hungry.

How is this related to investing?

We are more likely to be optimistically biased in our analysis if the market is doing well and pessimistically biased if the opposite is happening.

So you should only evaluate investment opportunities in a cold rational state when there’s no hype or panic in the markets. Don’t try to analyze bitcoin trading during its all-time highs, but do it when there’s no one else is talking about it. Investors should follow the Seven Ps rule: Perfect planning & preparation prevents piss poor performance.

Overconfidence / superiority trap

“The Greatest obstacle to discovery is not ignorance but it’s the illusion of knowledge.”

We tend to overestimate our abilities, thinking we are smarter than others and won’t repeat their mistakes. Studies have shown that 74% of people think they are better than average drivers and 80% of students think they’ll end up in the top 50% of their class.

This unjustified overconfidence significantly increases in experts, even if data has shown that their forecasts were mostly wrong. They tend to look for other justifications why their forecasts or analyses were not accurate.

Confirmation trap

“Confirmation bias is the most effective way to go on living a lie” 

This is a complimentary bias to our overconfidence trap, we tend to like getting confirmation/validation from other people in a similar situation. We love to see more analysts recommend, we not only look for the information that agrees with our hypothesis, but we tend to see all information as supporting evidence for it.

One way to overcome this trap is by proving yourself wrong first, that’s how the scientific method works. Instead of looking into what supports your idea, look for what might kill it.

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