Every one makes investment mistakes. From the time we were born, we learned from the mistakes we made. As investors, we need to learn from our investment mistakes by recognizing when we make them and make the appropriate adjustments to our investing discipline. When we make a losing investment, do we recognize our investing mistake and learn from it, or do we attribute it to some outside factor, like bad luck or the market? To make money from your investments and beat the market, we must recognize our investing mistakes and then learn from them. Unfortunately, learning from these investing mistakes is much harder than it seems.
Some of you may have heard of this experiment. It is an example of a failure to learn from investing mistakes during a simple game devised by Antoine Bechara. Each player received $20. They had to make a decision on each round of the game: invest $1 or not invest. If the decision was not to invest, the task advanced to the next round. If the decision was to invest, players would hand over one dollar to the experimenter. The experimenter would then toss a coin in view of the players. If the outcome was heads, the player lost the dollar. If the outcome landed tails up then $2.50 was added to the player’s account. The task would then move to the next round. Overall, 20 rounds were played.
In this study there was no evidence of learning as the game went on. As the game progressed, the number of players who elected to play another round fell to just over 50%. If players learned over time, they would have realized that it was optimal to invest in all rounds. However, as the game went on, fewer and fewer players made decisions to invest. They were actually becoming worse with each round. When they lost, they assumed they made an investing mistake and decided to not play the next time. Hauser Insurance
So how do we learn from our investing mistakes? What techniques can we use to overcome our “bad” behavior and become better investors? The major reason we don’t learn from our mistakes (or the mistakes of others) is that we simply don’t recognize them as such. We have a gamut of mental devices set up to protect us from the terrible truth that we regularly make mistakes. We also become afraid to invest, when we have a losing experience, as in the experiment above. Let’s look at several of the investing mistake behaviors we need to overcome.
I Knew That
Hindsight is a wonderful thing. As a Monday morning quarterback, we can always say we would have made the right decision. Looking again at the experiment mentioned above, it is easy to say, “I knew that, so I would have invested on each flip of the dice”. So why didn’t everyone do just that? In my opinion, they let their emotions rule over logical decision-making. Maybe their last several trades were losers, so they decided it was an investing mistake and they become afraid to experience another losing trade.