FOR BEGINNERS (PART VI)

II. c) Psychological Misjudgments

Human brain was designed to work in a wild world. Not that the present world is not wild but what was useful then may ruin you in the present day. You cannot rewire the brain, which seeks to help itself and regularly make shortcuts or automatic decisions without thinking (judgmental heuristics). That is what really useful for savvy sellers and very important to be aware of for investors.

Charlie Munger recommends knowing them by heart because the list is not long and this way the study would become applicable in practice (help to avoid problems).

I prepared a list of the most common and recurring misjudgments. The list really works for me - I memorized it and reread regularly. I know that I have similar points but with different framing – I thought that certain situations are easier to memorize as compared to dry theory.

In order to facilitate memorizing, I divided the list into 4 manageable sub-lists and I recommend devoting 15 minutes per day for each and in a week you will see the difference.

Before we go into the details, I would highly recommend the following links and books on the subject.

Charlie Munger’s Article on Psychology of Human Misjudgment - Link

Online Behavioral Finance Resource (very technical) - Link

Influence by Robert Cialdini - Link

Why Smart People Make Big Money Mistakes by Gary Belsky and Thomas Gilovich - Link

The Little Book of Behavioral Investing by James Montier - Link

List I

1. Mental Accounting. The key principle to remember: all money is equal. People tend to spent some money differently, e.g. inheritance, credit card or lottery winnings. If you play roulette and start with $1, then reach $100,000 and then lose it all. How much did you lose – most people will say that they lost a dollar.

2. Integrate Losses. Would you drive 4 blocks to get a lamp for $75 while at a store you are in it goes for $100? What if prices are $1,500 and $1,525? When you have a loss you prefer to hide it from yourself inside a bigger loss.

3. Asymmetry in Loss & Gain Treatment. A lost dollar is twice as painful as a gained dollar. That is how you avoid to get rid of your portfolio losers because until you sold it, it feels less painful. You start gambling with losers but are ultra conservative with winners. Scientifically, it is a part of a prospect theory and is called loss aversion and sunk cost fallacy.

4. Status Quo Bias. A variation of loss aversion. It may paralyze you, especially in the most important perceptively moment (decision paralysis).  You are simply avoiding a feeling of regret. This also explains why loss aversion can lead us to avoid or delay action. Addition of second good deal makes people less likely to take advantage of either opportunity. Remember March of 2009, when all had to invest while terrified and opportunities were plentiful (Link). How many dared to catch a falling knife?

5. Endowment Effect. People tend to overvalue what belongs to them - another manifestation of loss aversion and that is how trial periods and money back guarantees work. This explains why most people would demand at least twice as much to sell than they would to buy it.

6. Weber’s Law. The impact of change in the intensity of a stimulus is proportional to the absolute level of the original stimulus. When dealing about gain, difference between 0 and 500 is greater than between 500 and 1,000. When dealing about loss, difference between losing 500 and nothing is greater psychologically than that between losing 500 and losing 1,000.