The enemy in the mirror

Dear Gala,

In the last letter I told you that the market is very hard to beat. This one is about something harder to accept: the biggest threat to your money is not the market, and it is not the people in nice offices. It is you. Not because you are careless, but because you are human, and human beings were built for a world that had no stock markets in it.

Two psychologists

In 1974 two Israeli psychologists, Daniel Kahneman and Amos Tversky, published seven pages in a science journal that changed how we understand the mind. Their claim was simple. When people judge how likely something is, they do not calculate. They take shortcuts, and the shortcuts fail in the same directions every time, predictably.

You use these shortcuts every day. If a plane crashed on the news last week, flying feels more dangerous this week, even though nothing about flying changed; that is the shortcut they called availability. If a company has gone up for three years, it looks like a company that goes up, and you buy it as if the past were a promise; that is representativeness. If you bought something at a hundred, the number a hundred sits in your mind forever, and a price of ninety feels like a loss even when nothing about the thing is worth ninety; that is anchoring. None of this makes you stupid. It makes you a person.

Five years later they published the paper that won Kahneman the Nobel Prize. It showed how people actually feel about gains and losses, and the finding was this: a loss hurts about twice as much as a gain of the same size feels good. Losing a hundred dollars is roughly as painful as finding two hundred is pleasant. Once you know that, a great deal of strange behavior makes sense. People sell what has gone up, to lock in the good feeling, and keep what has gone down, to avoid the bad one, which is exactly backwards. People take wild risks to get back to even, because a loss on paper does not count until it is real. Every one of those choices feels reasonable from the inside.

What it costs

In 2000 two researchers named Brad Barber and Terrance Odean got their hands on the trading records of sixty-six thousand American households over six years and measured what all of this actually cost. The households that traded the most, the ones most confident in their own judgment, earned about eleven percent a year. The market earned about eighteen. The more people acted on their instincts, the worse they did, and the gap was almost exactly the cost of the trading. The title of the paper says it all: trading is hazardous to your wealth.

I want you to hold on to that number. Seven percent a year, for six years, lost not to a crisis or a fraud but to ordinary people being ordinary.

The part people get wrong

When people first learn about this, they get excited for the wrong reason. They think behavioral finance is a weapon: now I know the mistakes everyone else makes, I will profit from them. A few professionals do, at great cost, and we will talk about them in another letter. But for you and me it is not a weapon. It is a mirror. Its value is that it shows you your own face.

And here is the uncomfortable part, which Kahneman himself admitted late in his life: knowing about these mistakes does very little to stop you from making them. He studied them for fifty years and still made them. You cannot think your way out of being human. What you can do is build things around yourself so that being human costs less.

What actually works

Rules, written down in advance, on a calm day, for the days that are not calm.

I have a few. Before I buy or sell anything that matters, I write one paragraph: what I expect to happen, how sure I am, and why. A year later I read it. Most of the time the reasoning was worse than I remembered, and that is the point; it keeps me honest about how much I actually know. Whatever I add to the portfolio regularly, I add automatically, on a fixed date, so that no decision is made on a day when the news is loud. And I never sell anything on the day I decide to sell it. I wait. If the reason is still good a week later, I sell. It is remarkable how often it is not.

None of this requires intelligence. It requires admitting, once, on a good day, that you will not be at your best on a bad one, and arranging things so that your bad days cannot reach the money. That is what behavioral finance is for. Not to outsmart the crowd. To outsmart the version of yourself that shows up when you are afraid.

With love,
Papá