Battling Your Biases

Remember the day-trader cartoon in Chapter 1? The roller coaster called "The Day Trader" represents the modern investment environment. The roller coaster has dramatic highs and lows. As a modern-day investor, you can experience strong emotional highs and lows. This emotional roller coaster has a tendency to enhance your natural psychological biases. Ultimately, this can lead to bad investment decisions.

The previous chapter began the discussion of how to overcome your psychological biases. It introduced two strategies of exerting self-control: rules of thumb and envi­ronment control. This chapter proposes strategies for con­trolling your environment and gives you specific rules of thumb that focus you on investing for long-term wealth and on avoiding short-term pitfalls caused by decisions based on emotions.

The first strategy was proposed in Chapter 1: Understand the psychological biases. We have discussed many biases in this book. You may not remember each bias and how it affects you (due to cognitive dissonance and other memory biases—see Chapter 10), so reviewing them here should be beneficial. In fact, to help you make wise investments long after reading this book, you should re-familiarize yourself with these biases next month, next year, and every year.

STRATEGY 1: UNDERSTAND YOUR PSYCHOLOGICAL BIASES

In this book, there are three categories of psychological biases: not thinking clearly, letting emotions rule, and func­tioning of the brain. Let's review the biases in each category.

Not Thinking Clearly

Your past experiences can lead to specific behaviors that harm your wealth. For example, you are prone to attribute past investment success to your skill at investing. This leads to the psychological bias of overconfidence. Overconfidence causes you to trade too much and to take too much risk. As a consequence, you pay too much in commissions, pay too much in taxes, and are susceptible to big losses.

The attachment bias causes you to become emotionally attached to a security. You are emotionally attached to your parents, siblings, children, and close friends. This attachment causes you to focus on their good traits and deeds. You also tend to discount or ignore their bad traits and deeds. When you become emotionally attached to a stock, you also fail to recognize bad news about the company.

When taking an action is in your best interest, the endowment bias and status quo bias cause you to do nothing. When securities are given to you, you tend to keep them instead of changing them to an investment that meets your needs. You also procrastinate on making important decisions, like contributing to your 401(k) plan.

In the future, you should review these psychological biases.

Letting Emotions Rule

Emotions get in the way of making good investment decisions. For example, your desire to feel good about yourself—seeking pride— causes you to sell your winners too soon. Trying to avoid regret causes you to hold your losers too long. The consequences are that you sell the stocks that perform well and keep the stocks that perform poorly. This hurts your return and causes you to pay higher taxes.

When you are on a winning streak, you may feel like you are playing with the house's money. The feeling of betting with someone else's money causes you to take too much risk. On the other hand, losing causes emotional pain. The feeling of being snake bit causes you to want to avoid this emotional pain in the future. To do this, you avoid taking risks entirely by not owning any stocks. However, a diversified portfolio of stocks should be a part of everyone's total investment portfolio. Experiencing a loss also causes you to want to get even. Unfortunately, this desire to get even clouds your judgment and induces you to take risks you would not ordinarily take.

And finally, your need for social validation causes you to bring your investing interests into your social life. You like to talk about investing. You like to listen to others talk about investing. Over time, you begin to misinterpret other people's opinions as investment fact. On an individual level, this leads to investment decisions based on rumor and emotions. On a societal level, this leads to price bubbles in our stock market.

THE EFFECTS OF YOUR PSYCHOLOGICAL BIASES (CONTINUED).
Psychological	Effect on		Table
Bias	Investment Behavior	Consequence	15.1
Get Even	Take too much risk	Susceptible to big
	trying to break even	losses
Social Validation	Feel that it must be	Participate in a price
	good if others are in-	bubble which ulti-
	vesting in the security	mately causes you to buy high and sell low
Mental	Fail to diversify	Not receiving the
Accounting		highest return possible for the level of risk taken
Cognitive	Ignore information that	Reduces your ability to
Dissonance	conflicts with prior	evaluate and monitor
	beliefs and decisions	your investment choices
Representativeness	Think things that seem	Purchase overpriced
	similar must be alike.	stocks
	So a good company must
	be a good investment.
Familiarity	Think companies that	Failure to diversify
	you know seem better	and put too much
	and safer	faith in the company in which you wor