Investor Self-Delusions, Brain Damage and Jay Leno

Investor Self-Delusions, Brain Damage and Jay Leno

The philosopher Ludwig Wittgenstein once said that nothing is as difficult for people as not deceiving themselves. However, while most self-delusions may be relatively costless, those relating to investment can come with a hefty price tag.

We delude ourselves for a number of reasons, but the primary reason is biology: we are emotional creatures that use reason to justify how we feel. Several types of behavioral biases creep into our decision-making on a daily basis. “Loss aversion” is one of these biases and is best demonstrated in a study by Stanford professor Baba Shiv.

The Shiv study, which aimed to see the effect of emotions on making simple investment decisions, examined how well healthy adults performed compared to patients with damage to the emotion-processing regions of the brain. The rules were simple: Participants each got $20 they could use to place $1 bets on 20 tosses of a fair coin. Each losing bet would cost $1, while each winning bet would earn $2.50. The right decision is a no-brainer: Given the payout and the odds of winning, you should bet every time. However, anyone at all familiar with prospect theory in behavioral economics knows that is not what most people actually do. Irrationally, we are risk averse, finding the pain of loss much greater than the pleasure of equivalent gain. And, sure enough, in Shiv’s experiment the healthy participants passed up several chances to place a bet—and, as fear mounted with each subsequent coin toss, were less and less likely to take the gamble. As a result, they earned an average of only $22.80. The Mr. Spock-like patients earned $25.70, on average, because they remained unswayed by the fear of loss throughout the game.

This study became a punch line for Jay Leno on the Tonight Show, “If you’ve been banging your head against the wall, frustrated with your investment returns, you should keep banging your head against the wall.”

We also often look for external evidence that supports the myths we hold about ourselves, and we dismiss incompatible facts. Psychologists call this “confirmation bias”—a tendency to select facts that suit our own internal beliefs. A related ingrained tendency, known as “hindsight bias,” involves seeing everything as obvious and predictable after the fact.

These behavioral biases, or ways of protecting our egos from reality, are evident among many investors every day and are often encouraged by the media. Here are seven common manifestations of how investors fool themselves:

1. “Everyone could see that market crash coming.” If “everyone” could see a correction coming, why was “no one” profiting from it?

2. “I only invest in ‘blue-chip’ companies.” People often gravitate to the familiar. This familiarity and whether or not it is a good investment are not necessarily correlated.

3. “I’m waiting for more certainty.” Acting on those emotions can be counterproductive. Uncertainty goes with investing but long-term discipline has been rewarded.

4. “I know about this industry, so I’m going to buy the stock.” There are thousands of experts opinions already expressed in the market on a sector, industry, or stock. That information is already in the price. What you really should be stating is, “I’m smarter than all the other experts out there.”

5. “It was still a good call, but no one saw this coming.” Is that not the point? You can rationalize a specific bet as much as you like, but events or external influences can conspire against you.

6. “I’m going to restrict my portfolio to the strongest economies.” What moves prices are unexpected news and whether an economy or stock does better or worse than already expected.

7. “OK, it was a bad idea, but I don’t want to sell at a loss.” See the Shiv study or start banging your head repeatedly against a wall to think more rationally. Holding onto a losing bet can mean missing opportunities elsewhere.

Overcoming self-deception is not impossible. It just starts with recognizing that, as humans, we are not wired for disciplined investing. We will always find one way or another of rationalizing an emotional reaction to market events. That is why even experienced investors engage advisors who know them, and who understand their circumstances, risk appetites, and long-term goals. The role of that advisor is to listen to and acknowledge our very human fears, while keeping us in the plans we committed to at our most lucid and logical.


Kevin Kroskey, CFP®, MBA is President of True Wealth Design, an independent investment advisory and financial planning firm that assists individuals and businesses with their overall wealth management, including retirement planning, tax planning and investment management needs. This article adapted with permission from Jim Parker of Dimensional Fund Advisors.