It doesn’t matter how smart you are. Even the smartest people can make a bad investment decision.
Humans have innate, self-defeating characteristics (flaws) that can make us really bad investors:
Hindsight bias: this is a tendency to think that events are more predictable than they really are, and to look back on the past with a belief that you ‘saw it coming’. But that doesn’t really work when it comes to investing. The past, or your perception of it, is no predictor of the future. It’s great if a stock has done well in the past, but that doesn’t mean it will continue to perform. You can’t manage your investments by staring in the rear view mirror and telling yourself you ‘knew it all along’.
Confirmation bias: this is a habit of seeking out, and favoring, information that confirms what you already believe. Selectively picking out facts that bolster your ideas, and ignoring any reality that opposes your ideas, leads to overconfidence in your decision making.
Cognitive dissonance: this is the internal struggle that results form holding conflicting ideas. People have a natural desire to fix the discrepancy by reducing the importance of, or altogether changing, one of the dissonant ideas…often in favor of what is easy or comfortable. Easy and comfortable are not investment management tactics.
Status quo bias: this is an irrational preference for the current state of affairs. Change isn’t always easy…but who wants a status quo portfolio?
Sunk-cost fallacy: this is an irrational behavior that amounts to ‘throwing good money after bad’. A sunk cost is not recoverable…and when faced with that, investors tend to think they have already reached a point of no return and they can’t cut their losses. As they say, you’ve got to know when to fold ‘em.
Communal reinforcement: when an idea is repeated over and over again, it can take hold, even there is no evidence to support it. This holds true in the markets. But telling yourself ‘everyone else is doing it’ doesn’t hold any weight when following the herd hurts your portfolio.
Emotional biases are powerful influences. Keeping them away from your portfolio is easier said than done.