The twelve major pitfalls of investment: The greatest challenge in investing is 'knowing yourself.'

Source: Qile Club

Each of us has cognitive and psychological flaws, determined by the evolutionary process of our genes.

So, what cognitive biases primarily influence our behavior in investment? There are roughly twelve such biases, and achieving investment success requires overcoming these twelve major cognitive pitfalls.

1. Overconfidence

Most people suffer from overconfidence. One study tested participants for cholesterol levels and followed up months later to assess their recall of the results. The findings showed that participants with high cholesterol, who were most at risk of illness, were most likely to misremember their results. In their memories, the results were better than they actually were, meaning they believed themselves to be healthier than they truly were.

Various psychological tests conducted by researchers reflect similar outcomes: 82% of drivers believe their driving skills are above average; 84% of French men claim to be better-than-average lovers; 2,994 company founders estimated their chances of entrepreneurial success at 70%, while believing others had only a 39% chance. Ninety percent of stock market investors think they are better at trading stocks than others. Even most smokers believe they are less likely to develop smoking-related diseases compared to others. Our overconfidence is also evident when we attribute success to our own abilities but blame failures on bad luck, circumstances, or others.

In short, everyone seems to believe they are an exception to statistical norms or a fortunate individual favored by fate. On this point, 18th-century British poet Edward Young sarcastically remarked, “Everyone believes humans are mortal, except themselves.” Adam Smith also wrote, “The overconfidence of most people in their own abilities and foolish assumptions about their good fortune knows no bounds.” However, the truth is harsh. Our respected Mr. Munger is also an unsparing ‘sharp-tongued critic,’ once acerbically observing, “An immutable law of life is that only 20% of people can rank in the top fifth.”

2. Greed and Envy

Each of us, to a greater or lesser extent, possesses the flaw of greed, and jealousy is the twin sibling of greed. They exert a highly direct negative influence on investment. Charles Kindleberger, author of 'Manias, Panics, and Crashes: A History of Financial Crises,' made a classic statement: 'Perhaps the most troubling and vexing thing is to witness a friend amass great wealth.' Howard Marks also expressed a similar sentiment: 'Jealousy has a more adverse impact than greed, being one of the most harmful aspects of human nature. Most investors find it difficult to accept the fact that others are making more money than they are.' One significant reason why herd behavior in the stock market is so powerful is the sight of people around us earning profits, which drives us under the influence of envy and jealousy to chase rising prices. Such psychological stimuli were unavoidable even for brilliant individuals like Isaac Newton and Mark Twain.

Especially in today's era of self-media, stories of overnight riches occupy public attention daily. Greed and jealousy spread their wings as if they could fly. As the saying goes, 'The tree wants to be still but the wind won't stop.' How difficult it is to remain free from greed and jealousy!

3. Over-eagerness for quick success

In the realm of wealth, the trait of human impatience is even more pronounced. Once money is put into the stock market, one almost expects the stock price to rise in the next minute. A 10% annualized return is deemed unsatisfactory; ideally, one hopes for doubling each year. Keynes once said, 'Human beings instinctively crave immediate results, especially when it comes to making money quickly.'

The impatience of stock investors sometimes surpasses that of monkeys. After buying a stock, they frequently check trading apps and incessantly monitor stock price movements or repeatedly review their accounts. There is a famous American TV series called 'Seinfeld.' In this show, Seinfeld buys a junk stock and cannot resist the urge to keep checking its price from morning to night. When he picks up a newspaper, his date tells him, 'The price of this stock is the same as when you last checked; there has been no change since the market closed, and it is still falling.' He responds, 'I know, but this is a different newspaper... uh, I thought maybe it had a different... source of information.' According to a survey by Money Magazine, 22% of investors say they check the price of their invested stocks daily, and 49% do so at least once a week (WeChat Official Account ID: qlhclub).

Neuroscientific research has shown that every time we receive a reward, certain neurons in our brain release dopamine, which makes us feel pleasure. Therefore, people habitually enjoy receiving positive new information, gaining others' approval, or obtaining material incentives (even if they are trivial small gifts). If the stock I purchased keeps going up every time I check it, and every time I open my trading account, the numbers representing wealth jump upward, it is simply the most delightful feeling.

4. Endowment effect

The 'endowment effect' refers to the phenomenon where once a person owns an item, their evaluation of its value significantly increases compared to when they did not own it.

Even renowned economists known for their rationality cannot avoid such cognitive biases. For example, Richard Rosett, Dean of the University of Chicago Booth School of Business, was no exception. Rosett had a deep passion for wine and often purchased wines at auctions, typically not bidding more than $35 per bottle regardless of quality. However, for the wines in his personal collection, even if offered as much as $100 per bottle, he would refuse to sell.

This phenomenon is also quite common in investing. Initially, you may not understand a particular stock, but after being recommended by a friend or expert, you buy it, and from that moment on, you develop a special fondness for it. Buffett once mocked this phenomenon: 'A stock doesn’t know who owns it. But you invest it with all sorts of emotions: you clearly remember the price at which you bought it, and you vividly recall who shared some insider tips—your feelings run the gamut.' However, blind favoritism might just be the beginning of losses.

5. Anchoring Effect

The 'anchoring effect' refers to the tendency of people to place excessive weight on prominent or memorable evidence when making judgments. We are often anchored by the first number we hear or the first scene we encounter, and subsequently find it difficult to escape using them as a reference point in decision-making, even if the 'anchor' is merely an arbitrary assumption. In one experiment, naturalist Konrad Lorenz was accidentally seen by newly hatched goslings; they followed him persistently until they grew up, treating him as their mother! This 'gosling effect' is also a form of the 'anchoring effect'.

Most people live in a relative world, where they require a reference point to establish their value or guide their actions. In the story of 'carving a mark on the boat to retrieve a lost sword,' the passenger was misled by the reference point of the carved mark. How do we establish reference points in investment? Kahneman and Tversky discovered through research that reference points are related to several factors. The first and most important factor is historical levels, such as the cost price, the highest historical price, or the lowest historical price. The second reference point is the expectation level, which is your anticipated price. For instance, if you buy a stock hoping it will rise to $20, then $20 becomes your expected value. Reference points may also be influenced by the decisions of those around you; for example, if your friend buys a stock at $20, you may use that as your reference point. This is also known as the peer effect in decision-making.

When chasing gains, our internal reference point is often the historical extreme, with the subconscious thought being, 'I will sell once it breaks the highest historical price.' When trying to pick a bottom, our internal reference point is the historical low, with the inner voice saying, 'I will buy if it falls below the lowest price.' Meanwhile, when selling winners and holding losers, our internal reference price becomes the cost price, with the underlying thought becoming, 'I will sell once it returns to my cost price.'

6. Loss Aversion

In psychology, there is a specific theory that explains the asymmetry of psychological experiences, known as 'loss aversion.'

Daniel Kahneman provides the following example in his book *Thinking, Fast and Slow*:

A coin toss bet:

If it lands on tails, you lose $100.

If it lands on heads, you win $150.

This gamble appears quite attractive because the expected value of the bet is clearly in your favor. However, most people are still reluctant to participate in such a game, as summarized by Kahneman: for most individuals, the fear of losing $100 is stronger than the desire to gain $150.

Now, let's adjust this gamble by changing the winning amount from $150 to $200 if the coin lands heads. What happens then? Statistics show that many people expressed willingness to join such a gamble this time. In other words, the majority of people have a 'loss aversion coefficient' of 2. To explain it simply: the psychological impact of losses is twice as intense as that of gains of the same magnitude, or the pain caused by loss is twice as strong as the pleasure brought by gain. This is known as loss aversion.

Due to the psychology of loss aversion, we often make the mistake of 'selling winners and holding losers' in investments—securing profits quickly while stubbornly holding on to losing positions, which may exacerbate losses.

7. Excessive Fear

The emergence of fear has profound evolutionary roots. It is one of the emotional legacies left to us by our ancestors. As discussed earlier, in primitive jungle societies, our ancestors had to maintain optimism and sometimes even exhibited overconfidence to survive. However, there were two sides to the story—in non-urgent situations, they would choose to avoid danger. After all, the environment at that time was fraught with peril, where they could lose their lives at any moment due to predators, venomous snakes, or even conflicts among humans. When faced with these dangers, whoever reacted fastest to flee gained a chance at survival. Science writer Rush Dozier wrote in his book Fear Itself: 'Fear is a fundamental human emotion because life is the basis of all human activity. If we die, nothing else matters.' Survival is the highest law; those with the strongest fear reflexes survived, passing down this emotion through generations.

This evolutionary history has left physiological evidence. Deep within our brains, at a level parallel to the top of our ears, there are two almond-shaped clusters of neurons symmetrically distributed in the medial temporal lobe, known as the amygdala. Research generally agrees that the amygdala is the neural center responsible for forming fear memories, helping us avoid danger. The reaction speed of the amygdala is as fast as 12 milliseconds, 25 times quicker than the blink of an eye.

Excessive fear is often reflected in the stock market, leading investors to sell off their holdings in panic.

8. Herd Effect

There are many examples of 'conformity effects' in daily life. Here’s an interesting experiment: An uninformed participant A enters an elevator first and stands facing the elevator door, as per normal behavior. Then, two informed participants B and C enter successively but stand with their backs to the elevator door. A begins to feel uneasy and hesitates about whether to turn around. Next, another informed participant D enters, adopting the same stance as B and C. Although A feels puzzled, after a brief hesitation, A also turns around to align with the other three.

Humans generally do not directly acknowledge their own foolishness but instead use animals as metaphors. Earlier, we mocked ostriches; this time, it’s sheep. A flock of sheep is a highly disorganized group, often blindly charging left and right. However, once a lead sheep moves, the rest follow without hesitation—even if the lead sheep jumps off a cliff, the others will unhesitatingly follow. This is the famous 'herd effect.'

The 'herd effect' is particularly prominent in the stock market, leading people to chase rising prices and sell falling ones.

9. Linear Thinking

Linear thinking views problems in a straight-line, uniform, unchanging, and singular manner, with everything determined by the given initial conditions. When humans saw the first white swan, then the second, third... they concluded that all swans must be white. However, such 'seeing is believing' is unreliable, as Taleb summarized: '1000 days cannot prove you are right, but one day can prove you wrong.' Or as philosopher Karl Popper pointed out: 'No matter how many white swans we have observed, it does not prove the conclusion that all swans are white. Seeing just one black swan can refute it.'

In stock investment, there is a saying that 'three consecutive bullish lines change beliefs,' which is a typical manifestation of linear thinking. The market had been oscillating, leaving investors generally confused. However, due to specific events or other factors, the stock index rose for three consecutive days, lifting spirits and prompting many to increase their positions. Conversely, this is referred to as 'three consecutive bearish lines change beliefs.'

10. Story Thinking

Humans are naturally inclined to enjoy stories. To some extent, the stock market is driven by stories or narratives, which alter psychological expectations, leading to fluctuations in the stock market. As Frederick Lewis Allen, author of 'Only Yesterday: From the Boom to the Crash,' aptly summarized: 'Prosperity is not only an economic condition but also a psychological state. The great bull market was not only the peak of the business cycle but also the apex of the intellectual and emotional cycles of the American people. Almost everyone’s attitude towards life was influenced by the great bull market, and now they are struck by the sudden collapse of hope. With the quiet departure of the great bull market and the prosperous era, Americans found that their living environment had changed, necessitating new adjustments, new ideas, new habits of thought, and new values.'

Stories easily resonate deeply, and many investors become captivated by them, only to be swept into the vortex during market frenzies and pushed off a cliff during market crashes. Clearly, simplistic story-based thinking is undesirable.

11. Ignoring Asymmetric Risk

In the stock market, the mean will eventually revert, but the key lies in time. If you lack the strength or patience to wait for the reversion, tragedy is still hard to avoid. Tiger Fund, a famous entity in investment history, managed assets worth up to $22 billion at its peak in August 1998—far surpassing Soros’s Quantum Fund—and was the largest hedge fund at the time. Its founder, Robertson, was thus hailed as the most influential figure on Wall Street. That same year, the stock market entered the dot-com bubble, where technology stocks soared indiscriminately. Robertson, adhering to value investing principles, purchased large amounts of 'old economy' stocks based on his own criteria, but these stocks continued to plummet as market funds flowed into 'new economy' stocks. For instance, American Airlines, in which he held over 22% equity, lost nearly half its market value within 12 months. On the other hand, he used leverage to short non-profitable tech stocks, successively shorting two popular stocks, Lucent Tech and Micron Tech, but suffered significant losses.

In the first quarter of 2000, severe losses prompted investors to withdraw $7.7 billion, delivering a fatal blow to Tiger Fund. However, it was in March 2000 that the dot-com bubble began to loosen and subsequently burst. The mean finally reverted, but Tiger Fund was beyond recovery.

The world is divided into two: the physical world and the non-physical world. It is not incorrect to say that the world is symmetrical, but this statement must be confined to the physical world. If extended to the non-physical world, such as economics, finance, or the stock market, this proposition does not necessarily hold true. Although the stock market exhibits cyclical patterns, its cycles are not symmetrical like those in the physical world; rather, they are asymmetrical.

In investing, it is important to pay attention to both cycles and mean reversion, while also being mindful of the risks posed by such asymmetry.

12. Virtue Does Not Match Wealth

Sudden acquisition of immense wealth often becomes a major adversary to personal happiness. A review of lottery jackpot winners from around the world reveals life stories that frequently evoke sighs of regret. Faced with 'windfalls,' they tend to indulge in extravagant spending, debauchery, or fall prey to others' temptations, leading to reckless investments. Ultimately, not only do they lose all their capital and dissipate their fortunes, but they also often end up with broken families, and in the most tragic cases, commit suicide.

According to a survey by the National Bureau of Economic Research in the United States, over the past two decades, most jackpot winners in Europe and America fell into poverty within five years of winning due to excessive spending. The same survey indicates that the annual bankruptcy rate among American lottery winners is as high as 75%, with nine out of every twelve winners going bankrupt each year.

Without a healthy perspective on wealth, one is likely to fall victim to philosopher Arthur Schopenhauer’s curse: 'Wealth is like seawater: the more you drink, the thirstier you become.' Behind one’s view of wealth lies their outlook on life. When virtue does not match wealth, harm ensues instead.

Editor /rice