3 Powerful and Little-Known Psychological Investment Mistakes!
3 Powerful and Little-Known Psychological Investment Mistakes!
Today, we will talk about three little-known and yet very powerful psychological mistakes that many investors, beginners and pros, make all the time without even knowing it.
Today’s Episode is sponsored by Shortform!
1. Mental Accounting
Money should always have the same value to us. $1 is $1, and it should be perfectly interchangeable. But it’s not. This effect is called mental accounting. We categorize money into different buckets.
If you buy a shirt online but realize that you don’t like it as much as you thought when it was delivered, you refund it. But that money isn’t worth the same as before.
Since you assumed it’s gone (because of buying the T-shirt), you labeled it as a loss and are way more likely to spend it on something else rather than send it back to your account.
A similar effect happens in investing. As soon as you buy a stock, that money changes the mental label. You are unlikely to exit that position since that money is labeled as a loss anyway.
In this case, a loss doesn’t mean that you expect the stock to go down, but you know the money is gone from your bank account and thus not available for consumption (or anything else) anymore.
This is one of the reasons people hold on to losers for too long. I personally struggle with this, too. It’s a thin line between being a long-term investor in a company and someone who fails to exit a position that isn’t playing out.
2. Narrative Fallacies
One of the best ways to learn is from past mistakes. The problem is that many people use a flawed process to do so.
They look back at situations in which they either bought stocks that performed badly or didn’t buy a stock that turned out to perform great.
However, those narratives are mostly flawed and a product of hindsight bias and a lack of memory.
We overestimate how close we were to buying that winning stock, and we neglect the good reasons that caused us to buy the losing stock.
We tell ourselves flawed stories of the past that will now influence future decisions because we choose to “learn” from them.
The best way to learn from past investing mistakes is by keeping an investing journal. That way, you’ll avoid the trap of false memories and emotions. If you’re interested, I could write an article about how to structure an investment journal the best way.
Just let me know.
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3. Loss Aversion
I know this doesn’t sound like a little-known effect at first. But loss aversion has so many implications for investing that it’s much more than the standard definition we all know.
In its essence, loss aversion states that the fear of losing money is more intense than the feeling of happiness from an equivalent gain.
One of my favorite practical implications of this is in portfolio management. The most common method to “avoid” risk in investing is diversification. That’s how most people protect against risk (although it’s more a protection against volatility than risk; see here: Understanding Risk).
While I advocate focusing on the downside first and the upside later, this is not what I would do to avoid risk in investing.
I prefer to take loss aversion literally and invest in individual stocks that offer downside protection (to avoid a permanent loss of capital, not volatility!), while I do not limit my upside potential by “diworsifying,” as Charlie Munger would say.
Do you realize any additional biases or psychological flaws in your investing approach/thinking? Comment down below!
Have a great Sunday, and see you in the next Episode! (To all Paid Members, the next Deep Dive will be published on Friday and feature a phenomenal small-cap compounder!)
I’ll also increase the number of research articles for March and hope to average one per week!
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Best
Daniel
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