There are two key aspects to successful investing. One is technical knowledge: experience of an industry, ability to read financial statements, understanding of how different investment vehicles function and so on. This aspect is frequently covered on GuruFocus.
The second, but no less important, aspect to successful investing is mental. As humans, we suffer from a range of natural mental blind spots that can cloud our judgement when investing. As much as we would like to believe we are perfectly rational decision-makers, this simply is not the case - and that is OK. The trick is knowing where these blind spots lie and to plan accordingly around them.
Loss aversion
It is a well established fact that we feel the pain of loss much more acutely than we feel the joy of a gain. As a result, we will go out of our way to postpone that pain, regardless of the rationality of such a decision. In investing terms, this means we are more likely to hang onto a losing stock, even as fundamentals turn against us, in the hope the position will come back to scratch.
This, of course, is irrational - a loss on the computer screen is functionally equivalent to a cash loss, and no amount of wishful thinking will change that. Furthermore, we will run the risk of incurring further losses, as well as the opportunity cost of not being able to invest our capital in a better position. A related phenomenon to loss aversion is the endowment effect, in which we place arbitrarily higher value on objects we own relative to those we do not. This also causes us to hold onto losers longer than we should.
Illusory superiority
As humans, we tend to believe we are above average. Psychological studies have demonstrated that most individuals believe themselves to be more intelligent, more popular and more healthy than the average person (which is, of course, definitionally impossible). We even consider ourselves, ironically, to be less prone to bias than the average person. For investors, this overconfidence poses clear pitfalls. It causes us to overestimate our ability to pick winners and overcommit capital to a more narrow basket of stocks than rational risk-management would dictate.
Selective memory
This is a phenomenon linked to the problem of overconfidence discussed above. Given that most of us would like to believe we are above-average investors, we are wont to erase memories of painful losses. This propensity to black out negative memories is a normal part of being human - without it, we would be driven mad by thoughts of past mistakes. In the context of investing, however, where mistakes are valuable learning moments, this can be very dangerous. By erasing our missteps, we risk repeating them again and again.
Self-handicapping
Self-handicapping occurs when we ascribe future underperformance to some uncontrollable factor, i.e., “I had to drive my sister to the airport, so I didn’t have time to research that stock” or “I didn’t sleep well, so I’m not sure about this trade.” These are all attempts to explain away poor performance without addressing the root cause - ourselves. If we are making bad investment decisions, we need to be honest and work to correct them, rather than blame it on some exogenous problem.
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