The great Warren Buffet once said that you don’t need a super high IQ to be a great investor. What you need is the right temperament.
What exactly is the right temperament? A lot of it has to do with being able to self-examine and stay rational. Our emotions often trick us into looking at financial decisions in self-gratifying ways.
When we get a windfall, it’s tempting to splurge on spending or make wild speculative bets because it feels like we’re “playing with house money.” But a dollar is a dollar, whether it came by windfall or through grinding effort. The old saying easy come, easy go, may be true, but it reflects irrational investing behavior.
On the flip side, when an investment is losing money, many of us have the urge to hold on until we have recovered our principal. Or, even worse, we want to double down on a loser to get whole again faster. But throwing good money after bad is usually a losing strategy.
Both of these are examples of anchoring our thinking to an artificial idea about our past wealth. The windfall means that if we lose that money on a wild bet, it’s not really a loss. Selling for a loss is bad because we need to break even. This is not the path to great returns.
Great investors let go of the past and focus on finding the best opportunities available in the present. Sometimes, it really is best to cut your losses and reallocate capital to something better.
Emotional reasoning distorts the simple reality that a dollar is a dollar, no matter where it comes from or how we use it. The careful and rational investor remembers to treat every dollar the same.
Nobody is immune from these instinctive errors. Our human brains evolved to help us survive in the wild. We weren’t built for investing because not dying is a heck of a lot more important than finding market-beating returns. But if we can check our own irrational instincts, our investing returns improve.
Even after decades as a professional investor, I still watch myself carefully to avoid falling into traps. This is the domain of behavioral economics, which studies human irrationality. It’s very interesting to learn about. The hard part is putting it into practice every day.