What You Can Handle and What You |Think| You Can Handle
I’m a big rollercoaster guy. My five-year-old daughter knows it.
When we went to Peppa Pig theme park a month ago, she wanted to show me she was a big girl by riding the “thrill” rides.
There is a ride called Mr. Bull’s High Striker. This drop-ride lifts riders straight up to the sky (maybe one story) and gradually brings them down and up and down.
My daughter hesitated at first, but after she saw that I was interested in the ride, she started talking a big game about riding this big thrill ride with me.
We get in line, and suddenly, she disappears, stating she had to “go to the bathroom.”
Spoiler: she did not go to the bathroom. She did not want to ride Mr. Bull’s High Striker and left to ride a tricycle.
That, in a nutshell, is the difference between the ability to take risk and the willingness to take risk.
She could ride the ride (she’s old and tall enough) but wasn’t willing to do it when the moment of truth came (psychological and emotional).
It’s easy to be a daredevil when the rollercoaster is going up. It’s when it drops that we find out who’s actually strapped in for the ride.
Ability to Take Risk vs. Willingness to Take Risk: Lion King Edition
The ability to take risk takes into account your measurable financial situation (e.g., your income, net worth, debts, time horizon, and age).
The willingness to take risk is all about personality and emotional comfort with risk. Some people are naturally more cautious (think Zazu - the bird in The Lion King), while others are risk-seekers (think a young Simba).
But willingness can change quickly.
Do you remember when a young Simba visited the Elephant Graveyard? He was so eager to prove his bravery. Then, the hyenas appeared, and his bravery quickly changed to fear.
When stocks rise, people think they’re willing to take on more risk. When stocks fall, they suddenly realize they’re not as bold as they thought.
When emotions override logic, which typically happens in moments of stress and panic, we often make the worst possible decisions at the worst possible times.
These emotional hurdles are behavioral biases.
Five Behavioral Biases That Plague Us All
Loss Aversion
We feel the pain of a loss twice as much as the joy of a gain.
Investing example: Many investors quickly sell a stock after a small gain to “lock in profits” but hold losing stocks too long, avoiding the emotional pain of realizing a loss.
Overconfidence
Overconfidence bias causes an exaggerated view of the accuracy of our forecasts. Some believe they are smarter or more skilled than they are. This leads to a lack of open-mindedness and costly mistakes.
Driving Example: Do you believe you are an above-average driver?
If you said yes, you have agreed with about 90% of all drivers in a famous study of everyday people who said they were above-average drivers. Even though we know we all cannot all be above-average drivers, our minds tell us that we must be better than the rest.
Recency Bias
We give too much weight to recent events and assume they will continue. In part, that is because our brains have an easier time remembering what just happened versus what occurred further in the past.
Investing Example: Our portfolio drops 14%. Recency bias convinces us that it will continue to fall. Why did I choose 14%? Because that’s the average intra-year drawdown in any given year in the S&P 500. And guess what? The market continues to rise over time.
Herd Mentality
Herd mentality is the tendency to follow the crowd, even when it doesn’t make sense.
Investing Example: You see people making money on meme stocks or cryptocurrency, so you jump in at the peak—right before it crashes.
Men, it has been well said, think in herds. It will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.
– Charles Mackay
Sunk Cost Fallacy
We stick with bad decisions just because we’ve already invested time or money into them.
Investing Example: You buy a stock that keeps going down. Instead of cutting your losses, you hold onto it, telling yourself, “It’ll come back eventually.”
How to Overcome These Biases
The bad news? You can’t completely eliminate behavioral biases. They’re part of being human.
The good news? You can recognize them and build safeguards to keep them from wrecking your finances.
Here are a few ideas:
Have a Plan: Set your investment strategy ahead of time and stick to it.
Ignore the Noise: Financial news is designed to get clicks, not to make you a better investor.
Automate Your Savings: Take emotions out of the equation by setting up automatic contributions.
Our brains aren’t wired to handle investing rationally. We’re emotional creatures who react to fear and greed more than logic.
The market will always have ups and downs, but if you understand your own psychology, you can avoid making decisions you’ll regret later.
Now here’s what I’ve been reading and watching lately:
The story of Sol Price (his company merged with Costco) on Founders Podcast
The story of Les Schwab (Charlie Munger recommended this book) on Founders Podcast
All the different ways your life could have turned out by Morgan Housel
How To Know A Person by David Brooks
One of favorite children’s book (I have a 5-year old): The Rock From The Sky
