“The first principle is that you must not fool yourself — and you are the easiest person to fool.”
Anybody who has ever tried to beat the market knows that understanding psychology is just as important as understanding a business. You can know a company’s return on equity to the third decimal and what management likes to do with excess capital, but if you don’t understand prospect theory or confirmation bias, you’re missing the most important elements of what it takes to be a successful investor.
Studying investor psychology, however, is not enough, because the more we learn about it, the easier it is to become convinced that these foibles apply to other people and not to ourselves. You can read all the behavioral finance books in the world, but if you don’t apply this knowledge, you’re no better off than the investor who has never heard of Daniel Kahneman.
I traded full time for almost two years and most of what I learned can be boiled down to what everybody already knows: beating the market is ridiculously hard. But if everybody knows this, then why do so many try? And if they don’t know before they dive in, then why do people who fail to beat the market continue to try when their own experience suggests they can’t?
I suspect that people persist in failure because they don’t even know that they are failing in the first place. And they don’t know they’re failing because they don’t record and track their results.
It’s easy for investors to subconsciously inflate their track record because our memories mislead us. Memory is one of investor’s biggest blind spots.
Daniel Gilbert wrote about the dangers of relying on memory in Stumbling on Happiness:
Memory is less like a collection of photographs than it is like a collection of impressionist paintings rendered by an artist who takes considerable license with his subject. The more ambiguous the subject is, the more license the artist takes, and few subjects are more ambiguous than emotional experience.
Few subjects are more ambiguous than emotional experience, and few subjects provide a more emotional experience than investing.
I discovered relatively quickly how hard it is to beat the market. I’ve given a lot of thought into why I was able to escape self delusion and I’m convinced that the answer is really quite simple. I kept a trading journal. I was unable to fool myself into thinking I could beat the market because five days a week I physically recorded evidence to the contrary. For example, here is what I wrote when I shorted Amazon in February 2012:
News broke that their prime service added fewer than half of analysts estimates. Stock had been up 11% ytd. IMO based on meltup we’ve seen. Kindle fire has not been a success and when they announced very, very disappointing Q4 results, the stock traded down as low as 172, closing at 179.46. The price action recently has acted well due to the recent rally, which obviously could continue. Amazon has earned its ridiculous valuation, but its growth finally appears to be slowing.
A few days later I added to my short position, recording a similar entry of gobbledygook. I managed to exit the Amazon position without any financial damage, but what I gained was an invaluable experience. It would have been very difficult for me to continue to record these actions and thoughts without coming to any conclusion other than I should stop doing this.
Writing things down helped me see one of my biggest blindspots. I didn’t have to rely on memory for why I shorted Amazon and when and why I covered. Had I not written it down, it’s possible that I would have wiped that entire entry clean from my memory bank. Here’s Gilbert again on why relying on memory alone is not going to get it done:
We try to repeat those experiences that we remember with pleasure and pride, and we try to avoid repeating those that we remember with embarrassment and regret. The trouble is that we often don’t remember them correctly. Remembering an experience feels a lot like opening a drawer and retrieving a story that was filed away on the day it was written, but…that feeling is one of our brain’s most sophisticated illusions. Memory is not a dutiful scribe that keeps a complete transcript of our experiences, but a sophisticated editor that clips and saves key elements of and experience and then uses these elements to rewrite the story each time we ask to reread it.
If I never wrote down my experiences, it would have been easy for me to blame the Fed, or the shorts, or the future bag holders of Amazon.com. But because I recorded not just my results but also my thoughts, there was no one to blame but myself. The only reasonable place to arrive after two years was that I tried to beat the market and failed rather spectacularly.
The way we remember things is often very different from the way things happened. So one of the easiest ways to shine light on this blind spot and guard against it is to write things down. Whether you’re new to investing or are two decades in, keeping a physical record can be a good way to prevent being fooled by your future self.