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Four Pillars, part 3

“No matter how hard we try, we’re all hopelessly human.”

Understanding financial theory and history isn’t enough; we must also overcome our own psychology. The traits that allowed our species to survive for hundreds of thousands of years are not necessarily well suited to long-term saving and investing. Investing is not a race won by the fittest but by the patient and disciplined.

What are some of the biggest psychological obstacles? This is Bill Bernstein’s third pillar.

1) We are overconfident. We believe we know more than we do. We overestimate our ability to predict the future and even understand the past. We can’t reliably predict how we’ll react to adverse events. For example, a financial crisis that cuts our investment portfolio in half.

2) Mistakes were made (but not by me). We recognize the mistakes of others and can identify when others act irrationally. But we, for the most part, struggle to see those things in ourselves.

3) We assume the recent past will continue. “It is human nature to be unduly influenced by the last 10 or even 20 years.” We assume what’s recent is normal and ignore the lessons of history (see Part 2). For example, in 2020, article after article was written about how large cities wouldn’t survive, ignoring the evidence that cities had persisted for centuries despite past pandemics.

4) We overreact to the short-term. “We shouldn’t care about having a bad day or a bad year in the stock market as long as it provides us with good long-term returns.” We should take a longer-term perspective and focus on the larger context: are we saving enough, how do we cover expenses if we are no longer able to work, do we have a reasonable asset allocation, etc.?

5) We prefer stories to facts and data. We like simple explanations. We want to know why the stock market went up (or down) yesterday or last month even when we know the right answer – most of the time – is I don’t know or I’m not sure. We craft narratives (or accept the narratives of others) that convince us we understand “things that we are in reality clueless about.”

6) We see patterns and draw connections where none exist. For example, many believe good companies are good investments (sometimes they are but, on average, they underperform). Many believe fast-growing countries will deliver strong stock market returns (they typically don’t). There are many areas in which our intuition leads us astray.

7) We are most comfortable doing whatever everyone else is doing. This usually means investing in what has done well the last few years or decade. When others are excited, we tend to get excited. When others are fearful, we tend to be afraid. “The highest returns for an asset class usually occur when it becomes an object of popular revulsion.” Being a true contrarian is hard.

These (and other) psychological flaws can lead us astray. But there is hope. We don’t have to ignore our humanity to succeed as long-term investors. We should accept that we know less about the world than we think we do. That we (and others) cannot predict the future. That we make mistakes. That we are swayed by narratives. Awareness of our flaws can help us develop an investment plan that we will be likely to stick with through thick and thin. But before we get there, we have one more hurdle to overcome: the investing industry, which is very aware of our flaws.

Navigating the investing industry is Bill Bernstein’s fourth pillar (see Part 4).


Related posts: Part 1 (on theory), Part 2 (on financial history), Part 4 (on the investing industry), Part 5 (closing thoughts).

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