12 Cognitive Misconceptions in Investing: Overconfidence, Impatience for Success

Investment is a combination of science and art. The science of investment refers to aspects that can be "calculated," such as macro trend analysis, fundamental research on industries and companies, and valuation. The art of investment relates to cognition and mindset. Both aspects are equally important, but in practice, many people focus more on the scientific side while neglecting the artistic side, leading to some avoidable tragedies.

Looking back at investment history, it is not difficult to see that successful investors are often also masters of cognition and mindset, such as Warren Buffett, Charlie Munger, and John Templeton. In contrast, investors who once shone brightly but later failed miserably often did not fail due to science but due to cognition, such as the famous Wall Street stock trader Jesse Livermore and the Long-Term Capital Management company composed of multiple Nobel Prize winners. Even scientific giants like Newton suffered huge losses in stock investment, ultimately uttering the famous lament: "I can calculate the motion of heavenly bodies, but I cannot calculate the madness of people!"

Each of us has cognitive and mindset flaws, which are determined by the process of our genetic evolution.

So, what cognitive biases dominate our behavior in investment? There are roughly 12, and to succeed in investing, one must crack these 12 cognitive biases.

1. Overconfidence

Most people tend to fall into the trap of overconfidence. A study conducted cholesterol tests on participants and tracked their memory of the test results months later. The results showed that participants with high cholesterol, who were most likely to be ill, had the highest probability of misremembering their test results. In their memory, the test results were better than the actual results, meaning they believed they were healthier than they actually were.

Different psychological tests initiated by psychologists reflect similar results: 82% of drivers believe their driving skills are above average; 84% of French men claim to be above average lovers; 2,994 company founders believe their chances of entrepreneurial success are 70%, but they think others' chances are only 39%. 90% of stock investors believe their stock trading skills are better than others. Even most smokers think their risk of developing smoking-related diseases is lower than that of others. Our overconfidence is also reflected in the fact that when we succeed, we often believe it is due to our abilities; when we fail, we tend to blame luck, the environment, or others.

In short, everyone seems to think they are outside the statistical data, or in other words, the lucky ones favored by fate. In this regard, 18th-century British poet Edward Young satirized: "Everyone believes that man must die, except himself." Adam Smith also wrote: "The vast majority of people are overly arrogant about their abilities and the foolish assumption that they will have good luck." However, the truth is harsh. Our respected Mr. Munger is also a merciless "sharp-tongued gentleman," who once harshly commented: "The unchanging rule of life is that only 20% of people can make it into the top fifth."

2. Greed and Jealousy

Each of us has a certain degree of greed, and jealousy is its twin brother. They have a very direct negative impact on investment. A classic quote from Charles Kindleberger, author of "A History of Financial Crises," states: "Nothing is more distressing and headache-inducing than seeing a friend make a fortune." Howard Marks has also said something similar: "Jealousy has a more negative impact than greed; it is one of the most harmful aspects of human nature. Most investors find it hard to accept that others are making more money than they are." One important reason why the herd effect is particularly strong in the stock market is that seeing those around them making money drives people to chase rising stocks out of envy and jealousy. This psychological stimulus is difficult to avoid even for exceptionally intelligent individuals like Newton and Mark Twain.

Especially in today's era of social media, stories of overnight wealth capture people's attention every day, and greed and jealousy seem to have wings. "The tree wants to be still, but the wind does not stop," making it incredibly difficult to be neither greedy nor jealous!

3. Impatience for Success

In the realm of wealth, the human tendency to be impatient is even more pronounced. Once money is invested in the stock market, one wishes for the stock to rise within the next minute. An annual return of 10% is often deemed unsatisfactory; ideally, it should double every year. Keynes said: "Humans instinctively crave immediate results, especially when it comes to making quick money."

Stock investors can be more impatient than monkeys. After buying a stock, they frequently open market software to check the stock price trends or constantly check their accounts. There is a famous American TV show called "Seinfeld," in which the character George buys a penny stock and can't help but keep checking the stock price from morning till night. When he picks up a newspaper, his date tells him: "This stock is the same price as when you last checked; the market hasn't changed and is still going down." He responds: "I know, but this is a different newspaper. Uh, I think maybe it has different... sources." According to a survey by "Money" magazine, 22% of investors say they check the prices of their stocks daily, and 49% check at least once a week.

Neuroscience research shows that whenever we receive a reward, some of our neurons produce dopamine, which makes us feel pleasure. Therefore, people habitually enjoy receiving positive new information, gaining others' praise, or material encouragement (even a trivial little gift). If the stock I bought goes up every time I check it, and the number representing my wealth jumps up each time I open my trading account, it couldn't be more delightful.

4. Endowment Effect

The "endowment effect" refers to the phenomenon where once a person owns an item, their valuation of that item significantly increases compared to when they did not own it.

Even rational economists cannot escape this psychological pitfall. For example, Richard Rosett, the dean of the University of Chicago Booth School of Business, is such a case. Richard Rosett is very fond of red wine and often buys wine at auctions, but regardless of quality, he generally won't bid more than $35 per bottle. However, for the wine he personally collects, even if someone offers $100 per bottle, he will not sell This phenomenon is also very common in investing. Originally, you may not have understood a particular stock, but after being recommended by friends or experts, you bought it, and from that moment on, you became emotionally attached to it. Buffett has mocked this phenomenon: “Stocks do not know who their owners are. But you have projected too many emotions onto them: you clearly remember the price at which you bought in, and you also clearly remember who leaked some insider information—feelings are mixed.” However, blind favoritism may be the beginning of losses.

V. Anchoring Effect

The "anchoring effect" refers to the tendency of people to place too much emphasis on prominent, memorable evidence when making judgments. We are often anchored by the first number we hear or the first scene we see, and when making choices afterward, we find it difficult to escape from using them as references, even if this "anchor" is just randomly assumed. Naturalist Konrad Lorenz inadvertently became the first thing newly hatched goslings saw during an experiment, and they followed him closely until they grew up. He was regarded as their mother! The "gosling effect" is also a type of "anchoring effect."

Most people live in a relative world, needing a reference point to establish their value or guide their actions. In "carving a boat to seek a sword," the reference point that fools the ferryman is that scratch. How do we establish reference points in investing? Kahneman and Tversky found through research that reference points are related to several factors, the first and most important being historical levels, such as cost price or historical highs and lows; the second reference point is the expected value, which is your anticipated price level. For example, if you buy a stock hoping it will rise to 20 yuan, 20 yuan becomes the expected value. Reference points may also relate to the decisions of those around you; for instance, if your friend buys a stock at 20 yuan, you use that as a reference. This is also known as the herd effect in decision-making.

When chasing gains, our internal reference point is likely the historical extreme; the inner subtext is "I'll sell if it breaks the historical high"; when bottom-fishing, our internal reference point is the historical low; the inner subtext is "I'll buy if it falls below the lowest price"; and when selling at a profit or holding at a loss, our internal reference price is the cost price, at which point the inner subtext becomes "I'll sell if it returns to the cost price."

VI. Loss Aversion

There is a specific theory in psychology to explain the asymmetrical phenomenon of psychological feelings, known as "loss aversion."

Daniel Kahneman provided an example in his book "Thinking, Fast and Slow":

Betting with a coin toss:

If it's tails, you lose $100.

If it's heads, you win $150.

This bet seems quite attractive because the expected value is clearly in your favor. However, most people are still unwilling to participate in such a game, the reason being that, as Kahneman summarized, for most people, the fear of losing $100 is stronger than the desire to gain $150.

Now, let's adjust this bet by changing the winning amount for heads from $150 to $200. What happens then? Statistics show that many people express a willingness to participate in this bet. In other words, the "loss aversion coefficient" for most people is 2. In simple terms: the psychological impact of losses on a person is twice as strong as that of equivalent gains, or in other words, the pain of losing is twice as intense as the pleasure of gaining. This is loss aversion.

Due to the psychology of loss aversion, we often make the mistake of "selling winners and holding losers" in investments, quickly cashing out when we are in profit, but stubbornly holding on when we are in loss, which can likely exacerbate the losses.

Seven, Overwhelming Fear

The emergence of fear has profound evolutionary underpinnings. 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 exhibit excessive confidence to survive. But there are two sides to every story; they would also choose to avoid danger when not absolutely necessary. After all, the environment at that time was fraught with peril, and one could lose their life at any moment due to wild beasts, venomous snakes, or even the violent actions of other humans. In the face of these dangers, those who reacted fastest to flee were the ones who survived. Science writer Rush Doshi wrote in his book "Fear Itself": "Fear is a fundamental human emotion because life is the basis of human activity. If we are dead, then nothing matters to us." Survival is the highest law; those with the strongest sense of fear react the fastest, thus they survived and passed this emotion down through generations.

This evolutionary history has left physiological evidence. Deep within our brains, at the level of 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 believes that the amygdala is the neural center for establishing fear memories, helping us to avoid danger. The amygdala reacts so quickly that it takes only 12 milliseconds, which is 25 times faster than the blink of an eye.

Overwhelming fear is reflected in the stock market, leading investors to panic sell.

Eight, Herd Behavior

There are many "herd effects" in life. There is an interesting experiment: an unsuspecting test subject A first enters an elevator and stands facing the elevator door as normal. Then, two informed experimenters B and C enter the elevator one after the other, both standing with their backs to the elevator door. A becomes a bit uneasy and starts to hesitate about whether to turn around. Then another informed person D enters, adopting the same stance as B and C, and A feels strange but, after a brief hesitation, also turns around to align with the other three.

Humans generally do not directly point out their own foolishness but will use an animal as a metaphor; we have previously mocked ostriches, and this time it’s the sheep's turn. A flock of sheep is a rather disorganized group, often blindly bumping into each other. But once a lead sheep moves, the others will thoughtlessly follow suit, even if the lead sheep jumps off a cliff, the following sheep will jump without hesitation. This is the famous "herd effect."

The "herd effect" is very prominent in the stock market, leading people to chase after rising stocks and panic sell.

Nine, Linear Thinking

Linear thinking views problems in a straight, uniform, unchanging, and singular manner, where everything is determined by the initial conditions given. When humans see the first swan, which is white, and the second, third, etc., are also white, they conclude that all swans in the world are white However, such "seeing is believing" is not reliable, as Taleb summarized: "A thousand days cannot prove you are right, but one day can prove you are wrong." Or as philosopher Karl Popper pointed out: "No matter how many white swans we have observed, we cannot prove the conclusion that all swans are white. Just seeing one black swan can refute it."

In stock investment, there is a saying that "three consecutive bullish candles change beliefs," which is a typical manifestation of linear thinking. The market has been in a state of fluctuation, leaving investors generally confused, but due to specific events or other influencing factors, the stock index rises for three consecutive days, thus uplifting people's spirits and prompting them to increase their positions. Conversely, there is the saying "three consecutive bearish candles change beliefs."

Ten, Story Thinking

Humans have a natural inclination to listen to stories. The stock market is, to some extent, driven by stories or narratives; stories and narratives change people's psychological expectations, which in turn lead to fluctuations in the stock market. As Frederick Lewis Allen, the author of "Only Yesterday: An Informal History of the 1920s," summarized well: "Prosperity is not only an economic condition but also a psychological state. A bull market is not only the peak of a business cycle but also the peak of the American people's thoughts and emotional cycles. In this country, almost everyone's attitude toward life is influenced by the bull market, and now they are also struck by the sudden shattering of hope. As the bull market and the era of prosperity quietly fade away, Americans find that their living environment has changed, requiring new adjustments, new concepts, new thought habits, and new values."

Stories easily resonate with people, and many investors can be captured by stories, resulting in being swept into the vortex during market craziness and pushed off a cliff during market crashes. It is evident that simplistic story thinking is undesirable.

Eleven, Disregarding Asymmetric Risks

In the stock market, the mean will eventually revert, but the key lies in time. If you do not have enough strength or patience to wait for the day of reversion, tragedy is equally unavoidable. The famous Tiger Fund managed assets of up to $22 billion at its peak in August 1998, surpassing Soros's Quantum Fund by a large margin, making it the largest hedge fund at the time, and its founder, Julian Robertson, was regarded as one of the most influential figures on Wall Street. It was also in that year that the stock market entered the tech bubble, with technology stocks soaring. Adhering to value investing, Robertson bought a large number of "old economy" shares according to his standards, but these shares continued to plummet due to market funds flowing into "new economy" stocks, such as American Airlines, in which he held over 22% of the shares, losing nearly 50% of its market value within 12 months. On the other hand, he leveraged short-sold unprofitable tech stocks, successively shorting two popular stocks, Lucent Technologies and Micron Technology, but suffered significant losses.

In the first quarter of 2000, due to severe losses, investors withdrew a total of $7.7 billion, delivering a fatal blow to the Tiger Fund. However, it was also in March 2000 that the tech bubble began to deflate and subsequently burst. The mean finally reverted, but the Tiger Fund was already beyond saving 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 it needs to be limited to the physical world. When applied to the non-physical world, such as economics, finance, and the stock market, this proposition may not necessarily hold. Although the stock market has its cyclicality, its cycles are not symmetrical like those in the physical world; on the contrary, they are asymmetrical.

Investment must pay attention to cycles and mean reversion, while also being wary of this asymmetry risk.

Twelve: Virtue Does Not Match Wealth

Suddenly acquiring immense wealth often becomes a major enemy of happiness in life. A search of those who have won lottery jackpots, both domestically and internationally, reveals that their real-life experiences are often lamentable. Faced with "a pie falling from the sky," they often choose to squander it lavishly, indulge in pleasures, or succumb to others' temptations and invest blindly. In the end, not only do they lose everything and end up broke, but they often also suffer from broken families, with the most tragic outcome being suicide. According to a survey by the National Bureau of Economic Research in the United States, most jackpot winners in Europe and America have become impoverished within five years of winning due to excessive spending and other reasons. The survey also shows that the bankruptcy rate among American lottery winners reaches as high as 75% each year, with 9 out of 12 winners going bankrupt annually.

If one does not possess a healthy view of wealth, it is likely to fulfill the curse of philosopher Arthur Schopenhauer: "Wealth is like seawater; the more you drink, the thirstier you become." Behind the view of wealth lies the view of life; virtue does not match wealth, and one suffers as a result.