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Monday 16 July 2012

Mindless Money 1/5: Focus on Failure

If one theme emerges and re-emerges from the study of behavioral bias it's that humanity is endlessly over-optimistic about the future. No matter what life throws at us we never seem to get over this, and it’s probably a good thing that we don’t, since being depressed seems to be the only way to conquer over-optimism. 

Assuming that we’d rather not spend our lives attempting to make ourselves feel miserable then we need to take alternative steps to counter our rosy-tinged view of the future. A relentless focus on failure should do the trick. 

We know that over-optimism, anchoring, hindsight bias and a bunch of other behavioral biases are implicated in many of our poor investing decisions. We trade too much, fail to accept that our failures are our own fault and quite often simply don’t recognise that we’re losing money relative to the markets. 

As a matter of common fact we don’t seem to learn from our mistakes, even when the feedback is quite obvious. We have another bunch of mental ticks to help us in this unhelpful behavior – stuff like money illusion, mental accounting and, in particular, loss aversion, where we often avoid actually taking a loss in order to maintain the illusion that we’re better investors than we actually are. 

Mostly this is mindless behavior – we don’t really think carefully about this stuff. If we did we wouldn’t do it. We behave mindlessly, operating on behavioral autopilot and navigating straight into the problems that we ought to be avoiding. Instead we need to try and focus our attention on the aspects of investing that induce the opposite of mindlessness – those that force us to think through the potential consequences of our decisions. 

One of the critical things that seems to help enforce mindfulness is a focus on failure. Being preoccupied with failing may seem an odd thing to suggest to an investor, but each and every failure, and near failure, offers us many more learning opportunities than all the successes we may ever have. After all, if we succeed we may have been lucky, but if we fail we certainly haven’t been. 

Not only should we conduct autopsies on our failures, we should look hard and long at our near failures as well, and we should continually review our successes to try and figure out what bad habits they may be lulling us into. Success, particularly repeated success, is particularly likely to encourage us into bad habits: a good investor should never assume that success is equivalent to competence – we need to avoid habituation and the inattention that comes from it. Simply repeating what’s worked in the past is a one way ticket to a future mistake. 

Most people focus – and talk about – their successes. We would be better off developing forums to place our failures under the microscope and force ourselves to think through what actually went wrong with our decision making. It’s an uncomfortable thing to do, but if nothing else it might make us feel a bit depressed: which will make us a better investor. There’s a bright side to everything, if you look hard enough for it.  

Further reading:

That people are more rational investors when they're depressed is covered in Depressed Investors Don't Need Feedback, Everyone Else Does. Our most popular investing biases are covered in the Big List of Behavioral Biases while Money Illusion and Mental Accounting have their own specific articles.  Our inability to avoid being overoptimistic and to ignore the most obvious feedback is covered in Clueless: Meet The Overprecise Pundits and in other articles too numerous to mention.  Finally the idea that we communicate a warped impression of investor success is discussed in Facebook Friends Can Make You Poor.

Next >> Mindless Money 2/5: Don't Oversimplify

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