In the past, we’ve talked about how many studies show that individual investors underperform the broader stock market.

Of course, we each have our own unique needs and goals, and sometimes they don’t require major gains. Things like capital preservation or income are important in some situations, too.

But what really tends to ruffle some feathers is when I say that most individual investors are bad at investing. I don’t say this to be deliberately controversial. I say it because it’s what people need to hear.

In a raging bull market, it’s easy to feel like a genius. Don’t get me wrong… big wins are great. But part of our job is to not only provide ideas in the form of stock picks — but to help you actually be better than the average investor.

To do that, one of the things we have to do is go back to try and understand why most individuals are bad at investing. If we can wrap our heads around that, we can begin to remedy the situation.

And that’s why it’s essential to understand some basic human psychology. So let’s have a little fun today with a thought experiment…

Heads Or Tails…

First, I’ll present two scenarios. Then I’d like you to think about what you would do in each one.

Scenario 1: Imagine that you have just been given $1,000. You have to choose between two options. With option A, you are guaranteed to win an additional $500. With option B, you are given the chance to flip a coin. If it’s heads, you receive another $1,000; tails, you get nothing more.

Which option would you chose?

Got that? Good, now stay with me here…

Scenario 2: Now imagine that you have just been given $2,000. You must choose between two options. With option A, you are guaranteed to lose $500. With option B, you are given the chance to flip a coin. If it’s heads, you lose $1,000; tails, you lose nothing.

Now which option would you choose?

I picked this up from Gary Belsky and Thomas Gilovich’s book “Why Smart People Make Big Money Mistakes.” I’ve mentioned this book off and on over the years — it really is one of the best books out there if you want to understand behavioral economics. (I highly suggest you pick up a cheap used copy on Amazon or at your nearest bookstore. It’s a quick read.)

Here’s what they have to say about the two scenarios…

Traditional economic theory used to tell us that the market is made up of rational actors. This means people make rational financial decisions based on the probability of future events. And by this logic, you would be consistent with your decisions in both cases.

After all, if you choose option A in scenario 1 and scenario 2 — the certain gain in the first version or the certain loss in the second — you end up with $1,500 either way. With option B, you have a fifty-fifty chance of ending up with $1,000 or $2,000 in each scenario.

See what I mean? (Go back and re-read this if you need to…) In other words, the only thing that should matter to you is whether you’re willing to take the certain but smaller gain or whether you’re willing to gamble to win more money.

Make sense? There’s just one problem, though…

As Belsky and Gilovich point out, that’s not how most people think. When they tested these scenarios on a group, nearly all chose option A in the first (guaranteed to win an additional $500) and option B (lose $1,000 with heads, lose nothing with tails) in the second.

Think about that for a second. Why on earth would they do that? It makes no sense!

The answer is easy. It’s because they’re human…

The field of behavioral economics teaches us that humans are not rational when it comes to finances. This is apparent in the two scenarios above. Humans tend to be more conservative when it comes to booking a sure gain, whereas we’ll take more risk if it means avoiding certain losses.

As Belsky and Gilovich note, this explains why gamblers tend to increase their bets when they start losing money. They’re willing to be more aggressive to avoid finishing in the red. It also helps explain why most investors sell their winners too early and hang on to their losers for far too long. The fear of losing money on a stock is far more potent than the joy of achieving additional gains.

The Takeaway

Ask yourself how many times you’ve sold a winning stock just to see it surge in the days and weeks that followed. On the flip side, think about how many times you’ve held on to a loser just to see it keep falling. As you can imagine, this tendency can have a devastating effect on an investor’s portfolio.

Terrance Odean, another behavioral economist, found that the stocks investors sold outperformed those they continued to hold by roughly 3.4 percentage points in the 12 months following the sale. You don’t need a Ph.D. to understand that, over time, those 3.4 percentage points add up.

It’s important to understand our psychological makeup as humans. What’s more, understanding what makes us tick personally is even more crucial. We all have them. And if we work to overcome those tendencies, our portfolios will be on the path to bigger profits.

If you’re interested in learning more, here’s a short list of cognitive biases from Magellan. If you scan through them, you might be surprised to see which ones you have.

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