The first principle is that you must not fool yourself—and you are the easiest person to fool.
I want to share a little story from a couple of years ago. It’s pretty embarrassing to air it in public like this, but it’s for a good enough cause that I decided to bite the bullet.
Back in 2015, I hadn’t yet embraced the sweet serenity of passive investing. I was still picking individual stocks, and doing pretty well for myself. I probably thought I was hot shit.
There was this one company I’d been following closely for ages. It was in trouble, but far from a lost cause. Everyone was piling out of the stock, to the point where it was valued four times less than it had been only a couple of years earlier. There was a whole lot of smoke blowing around, but no actual fire. It looked like an amazing opportunity to take money from all the scaredy-cats.
I had rules about investing. I never put more than 5 per cent of my portfolio into any one stock. But this opportunity was too good to worry about stupid rules, so I got in—and heavily.
The smoke didn’t clear. Instead, it got thicker and oilier. It turned out there were some flames licking away too. The stock halved in value again. Even though I was heavily in the red, I wasn’t too worried. I knew the fundamentals were OK—it had good bones!—and even in the worst-case scenario it would still be undervalued.
So I bought more shares at the ‘cheaper’ price. When the company inevitably recovered, I’d make a killing. Sure enough, the stock bounced up and got me almost out of the hole. I was pretty proud of myself for having the balls to double down, and also more than a little bit relieved.
What I didn’t understand is that if it falls from a great enough height, even a dead cat bounces once (this gruesome metaphor comes to you courtesy of the finance industry). The whole company burned down to the ground. All sorts of crazy shit came out of the woodwork, and every bad thing that could happen, did happen. By the end, I’d lost US$10,000.
All of this was happening at the same time I was hustling my butt off to reach my $100,000 target, so I could go traveling and take a long sabbatical to work on my projects. The loss set me back a long way, and I didn’t end up hitting six figures until a couple of months after I’d moved overseas.
How to Catch a Falling Knife
It is a bitter blade, and steel serves only those that can wield it. It will cut your hand as willingly as aught else.
— J.R.R TOLKIEN
In the restaurant industry, a falling knife has no handle. You never, ever try to snatch it out of the air. Just let it fall. Every chef who still has 10 fingers knows this.
In the finance industry, catching a falling knife is fun and games!
‘To catch a falling knife’ means buying a stock or other asset while its price is tumbling. If you can snatch it up right at the point it stops falling, you’ll make a killing on the way back up.
I stretched out my hand, and that knife went right through me without so much as slowing down. Being a slow learner, I bandaged up the wound and put out my hand again. This time, it took a finger off. I wasn’t the only one bleeding out.
By the time the knife clattered all the way to the floor, it was surrounded by a pool of viscera that made Saw look like a Disney film.
An investing expert would say that I’d messed up the calculations, that my information was bad, and point out that I’m an idiot for breaking my investing rules. In other words, I need to a) work on my knife-catching reflexes, and b) get more disciplined about when I choose to dart my hand in.
That’s all fair criticism. But the obvious, idiot-proof response is simpler: Stop fucking around with sharp things.
Catching a Falling Knife While Blindfolded
Our comforting conviction that the world makes sense rests on a secure foundation: our almost unlimited ability to ignore our ignorance.
— DANIEL KAHNEMAN
There’s this idea in financial circles that to be a successful investor, you just need to act without emotion—be greedy when others are fearful and vice versa, follow your pre-determined rules, take a loss when required.
Outside of Star Trek and Ayn Rand novels, truly rational people don’t exist. The field of behavioural economics has uncovered dozens of hard-wired cognitive biases: little quirks which muddy our thinking, and make us do dumb shit pretty much all the time.
Let’s run through the main ones that sabotaged me:
Everyone is far more confident in their predictions than they ought to be, especially ‘experts’. I was no expert, but I was an up-and-coming business reporter who followed the markets all day, interviewed top CEOs, could sort of read a balance sheet, and had several previous investments play out very well. A little knowledge is a dangerous thing.
I had ample opportunity to cut my losses and sell out, but I was way too heavily invested in the company (literally and figuratively). The sunk-cost fallacy is linked to loss aversion: people hate losing much more than they enjoy winning. And so, rather than take a haircut and officially become a Loser, I kept throwing more good money into the smouldering dumpster fire.
Everyone selectively filters for information that supports their existing worldview, and tries to bend new evidence to fit the narrative. Think of the hideous contortions your Very Political friend performs when their team does something awful. My analysis of the stock was probably more wishful thinking than it was an objective view of reality, especially once I was defending an entrenched position.
These kind of cognitive biases literally distort our perception of reality, and blind us to what’s really happening.
Catching a Falling Knife While Hallucinating
Let’s extend our metaphor: You’re now trying to catch a falling knife while not just being partially blinded, but hallucinating that the knife is, in fact, a cuddly bunny rabbit.
Couldn’t a savvy investor just school up on all these sort of biases, and stop them from influencing their decisions? You could try. But in doing so, you’d only be fooling yourself on an even deeper level!
Our brains take these mental shortcuts at lightning speed, rather than using the careful and measured ‘type 2’ system of thinking. By definition, we’re often oblivious to this happening, which means we work backwards—starting out with an unconscious decision, and then using complicated rationalisations to justify our way back to the original intuition. Weirdly, learning about this stuff can actually make you even more overconfident, because you think that you’ve identified and adjusted for your biases.
Rather than trying to confront biases head-on, it’s better to come up with systems that take them right out of the picture. If you’re hiring, that might mean screening applicants without seeing a photo, so you don’t accidentally give all the jobs to sexy people (seriously), or discriminate against people from your outgroup.
In investing, it might mean having automated rules you can’t violate, or using algorithms to make decisions, rather than relying on human judgment. These will help… but only to bring you up to the baseline of being not-terrible.
The best possible outcome is that you end up an average investor.
This is nowhere near as depressing as it sounds! And there are much easier ways to get there than having to constantly do battle against yourself.
In Defence of Laziness
I promise that this isn’t me being bitter after making a bum trade. On the whole, I’ve done pretty well. It’s just an acknowledgement of reality.
Let’s say you were half-Vulcan, with a mind like a steel trap, and were never swayed by emotions or biases. It still wouldn’t matter a jot. You’re not going to consistently beat the market over time, except by luck.
Stock pickers and fund managers do no better than monkeys flinging shit at the business pages of the newspaper. Some of them keep getting lucky, which gives the illusion of skill.
Others (like Warren Buffett) have access to amazing sweetheart deals, completely out of reach for normal people. I’ve covered all of this in great detail here, so I won’t relitigate the point.
The conclusion I’ve come to is that passive investing is about as good as it gets. Instead of trying to make predictions, you invest in a fund that buys a tiny bit of every single company, then kick back and do nothing at all. There’s no time wasted on research, no fooling yourself, no worries about biases. Note that this is how Buffett wants his wealth managed when he dies.
We’re taught from childhood that the harder you work, the greater the rewards. This is one of those counterintuitive situations where being a lazy slob is actually the smartest choice.
Skinned Knees and Falling Out of Trees
If you’re not making a mistake a year that really hurts, you’re not moving fast enough. You’re too cautious, you’re too wimpish. Your goals are too easy. You’ve got to push. So make mistakes, but learn from them. Never make the same mistake twice.
— SIR MICHAEL HILL
One of my goals for this year was to live on less than US$10,000. So far, I’m (just!) on track to hit that target. That means the money I lost could have bought me an entire extra year of freedom to keep roaming around and doing fun shit.
But I haven’t lost any sleep over this whole mess. I’m actually kind of grateful. If my gambit happened to work out, it would have been pretty tempting to think of myself as some sort of investing guru, even though the underlying reality wouldn’t have changed. Maybe my head would have got stuck so far up my ass that I’d make an even bigger mistake.
The other silver lining is being able to share this little story, and hopefully prevent other people from being as dumb as me.
My dad always told me that ‘only a fool never makes mistakes’. This only recently clicked into place for me. Even when things don’t work out the way you wanted, you might learn something more important along the way.
That’s why I’m not totally against picking stocks. Rationally speaking, it’s dumb. But it’s fun. It got me hooked on investing, and reinforced my frugal habits. I couldn’t wait until I had enough cash saved up to start hunting for my next investment. In the process, I learned a lot about all sorts of interesting topics.
I’ve been advocating for set-and-forget passive funds for years, even while I was hypocritically still picking stocks. I’m more-on-less on track now, but I had to:
a) lose a lot of money, and
before I started taking my own advice.
If you’re anything like me, maybe you need to get bloodied up a couple of times. After all, kids have to fall out of trees and scrape their knees and burn themselves on the stove before they can start to understand risk.
Apparently, I’m a slow learner. Hopefully you wise up sooner than I did.
The public library will loan you these books for free. If you’d rather buy them, the affiliate links on this page send a few pennies to support this site, at no extra cost to you (read more here).
This is your primer for cognitive biases and rationality 101. Some of the studies Kahneman talks about have failed to survive the replication crisis in psychology (maybe read it with this companion guide) but the rest is solid. It’s accessible for laypeople, and one of the most fascinating books I’ve ever read.
This book sums up 20 years of research on forecasting, explaining why experts so often get it wrong. It’s more than just a cautionary tale though. Some great takeaways arise from examining a group of ‘superforecasters’—most of them ordinary people—who managed to beat the best decision-makers in a giant prediction tournament.