Our brains have a wonderful, weird ability to make quick sense of the world through mental shortcuts. Yet, those shortcuts often fail us when it comes to money and investing.
For instance, investing is one activity where outcomes are not always obvious thanks to uncertainty. You can make the right decision and still lose money. You can also make the wrong decision and profit. So our mind fills in the blanks in a way that makes sense of it all. The result, however, can leave a false impression of the impact of skill and luck — both good and bad — on investment results.
A 1983 study by Thomas Gilovich suggests that it happens quite often. His study looked at how gamblers rationalized their success and failure from betting on football games. They were asked to record their thoughts about the outcome of bets under the guise that it would improve their betting later in the season.
Gilovich found that gamblers accounted for their wins and losses differently. It turns out, gamblers burned more mental energy to explain a loss compared to a win.
Losses were often explained away by a fluke event. A player got hurt or the ref made a horrible call that turned the tide of the game. That’s what led to the gambler’s loss. It was just dumb luck. Otherwise, the gambler was sure to win.
Wins, however, were practically assured. The gambler was supposed to win. They were right after all. And in a few cases, their thoughts led them to believe the outcome of a game should have been more extreme than it actually was. Had that player not gotten hurt, it would have been a bigger upset.
The results show that gamblers revise the history of losses while accepting wins at face value. They substitute skill or luck when it best suits them. When they made money it was skill. But when they lost it was dumb luck.
Probably most surprising, the study found that the gamblers remembered their losses better than their wins weeks later. Because they spent so much time and energy “analyzing” losses more than wins, they not only remembered the losses but saw those losses as near wins.
Of course, investors and traders do the same thing. Wins are expected (nobody makes a trade expecting to lose). It’s supposed to happen. No need to waste much energy figuring out if your decision was correct when you made money.
But losses…it’s easy to twist a reality of a loss into an aberration. I’d have a profit if it wasn’t for the meddling Fed. Had inflation not spiked, I’d have made money. War, politics, weather, and more are on the table to explain why a loss was really a near win.
Of course, the consequence of believing a loss is not a loss is that it’s easy to make another trade when you were this close to a sure thing. In fact, there’s a good chance you’ll continue to believe you have some ability to pick winners when you likely don’t.
What’s worse, viewing a loss as a near win, likely guarantees you never learn from your losses either. And if you never learn, then you’ll repeat it again and again.
One solution to this problem is to define what success and failure look like for each investment in advance. Does success mean making money? Does failure mean losing? Or is there more to it? Maybe success is defined as being right and making money. And a failure is simply being wrong. Feel free to be as specific about this as you like.
The next step would be to expand on this with an investment postmortem once described by Bernard Baruch like this:
I developed a habit I was never to forsake — of analyzing my losses to determine where I had made my mistakes. This was a practice I was to develop ever more systematically as my operations grew in size. After each major undertaking — and particularly when things had turned sour — I would shake loose from Wall Street and go off to some quiet place where I could review what I had done and determine wherein I had gone wrong. At such times I never sought to excuse myself, but was concerned solely with guarding against a repetition of the same error.
Investment postmortems are a good habit for investors to undertake. The purpose is to dig through the decision-making process behind each investment to see if a poor decision was behind a loss. It’s a way to collect mistakes in an effort to not repeat them again. The end result of those two steps should be far better than treating losses as near wins.
The Stock Market is People
Biased Evaluation and Persistence in Gambling