Mental Illusions: When Your Brain Tricks You into Losing Money

“I know I’m quite smart, so why can’t I invest better?” wondered Simcha Goldman. Simcha always seemed to be a step or two behind when it came to making good financial decisions. He dabbled in stocks, real estate, and even cryptocurrency, and while he did make some money, the results were never impressive. What had initially seemed like a streak of bad mazal seemed to be more deeply rooted.

Apparently, aboveaverage intelligence wasn’t bringing him aboveaverage investment results. Why not?

Perhaps Simcha is suffering from mental biases. To enable lightning-quick decisions, our brains sift through vast quantities of accumulated memories using certain mental shortcuts, or heuristics. While heuristics help us reason and respond, they also often lead to mental blind spots or biases, causing us to act less than perfectly rationally. Psychologists and behavioral economists (who study where psychology and economics intersect) have documented many of these irrational quirks of the mind, and learning about them can be both interesting and useful. By understanding cognitive biases, we can better overcome them, leading to better decision-making—whether in finance or in other aspects of daily life.

Recency Bias

One way the brain ranks the importance of a particular memory is based on how recent it is. So, when people are asked to assess the risk posed by a potential car crash or rare disease, recent headlines mentioning the occurrence of that particular tragedy have a significant effect on their responses. The fact that a horrible car accident has taken place doesn’t make it more likely that another one will occur, but because that memory is fresh, the brain overestimates its likelihood of recurring even if the probability hasn’t changed at all.

Number Anchoring

In a similar vein, behavioral economists conducted a study in the late 1970s in which they spun a wheel with the numbers one through 100 in front of test subjects. They then asked those subjects what total percentage of UN membership was accounted for by African countries. The result was that the lower the number that appeared on the wheel, the lower the average estimate provided by the participants, even though the wheel had nothing to do with countries in Africa! Having a random number anchored in their brains, even momentarily, affected their next thought process or decision.

Anchored Investors

These biases very much affect investing, as they do all other aspects of our decision-making and thought processes. Say Boeing stock has been trading for a while at $100 a share. Then, some serious new issues arise which significantly lower the company’s prospects and the shares’ intrinsic value, but investors may still tend to assume that $100 is the right price for Boeing shares because they mentally anchored themselves around that number. Similarly, someone who gets used to a world of finance without a metaverse and self-driving cars may become too anchored to that reality and miss burgeoning new realities on the ground.

Recent Events Don’t Dictate the Future

Investors may rationally know that they should be buying low and selling high, but due to recency bias, they often assume that recent bad news or good news will persist. In reality, at some point a depressed investment available at a heavily discounted price becomes very attractive and vice versa. Overcoming recency bias is therefore vital to buying and selling at the most opportune times.

Emotional Dependency, Financial Version

Another common cognitive bias is the sunk cost effect. This is a tendency to continue an endeavor once an investment of money, effort, or time has been made and resist changing to another option that might have become more suitable. For example: A person purchased a nonrefundable vacation or tour but later gets invited to a close friend’s simchah, scheduled for the same day. If not for the sunk cost of the ticket, they would choose the simchah over the vacation (i.e., if they were offered a free vacation but would miss the wedding if they accepted, they’d prefer the wedding). But to avoid the “loss” of the ticket, they go on the vacation despite it currently being the less preferred option.

Cutting Losses Is Emotionally Difficult

The sunk cost effect explains why many investors hold onto investments even after they’ve proven to be stinkers. If it’s a stock or investment property that you wouldn’t buy today, rationally, why keep it? Selling it now is the equivalent dollars-wise to not buying it. But human nature being what it is, “locking in a loss” causes discomfort which we mentally try to avoid, even if it’s not purely logical. We try to protect the “sunk money” even though it’s already spent. We are loss averse and want to avoid the bad feeling that comes with the knowledge that we made a bad a decision in the past.

Is Everyone Extraordinary?

There are many documented mental biases, but our tendency to overestimate ourselves may be the most fundamental of them all. When you ask people to rate their own intellect, looks, or even driving skills, most tend to say, “I’m well above average.” Now, if you think about that for a moment, you’ll realize that it’s mathematically impossible for most people to be above average! But that’s how humans tend to think.

This natural overconfidence leads to bad decisions. People who think they’re better than they really are get into situations that are over their heads. In the investing world, most should stick to simple, solid investments because they are probably not as good at selecting and managing investments as they think.

“New” Research

In the 20th century, behavioral economist’s work was considered groundbreaking, but Chazal noted these concepts long ago. Loss aversion spelled out in Bava Kama (85a), is rooted in the endowment effect, which Chazal referred to as, “Adam rotzeh b’kav shelo m’tishah shel acheirim. (A person would rather have his own Kav than someone else’s nine Kav measures)” (Baba Metiza, 38a). The aforementioned self-overestimation, or “Ein adam ro’eh nigei atzmo” (Negaim, 2.5) —allegorically explained as “A person does not see his own flaws,” is largely why mashgichim say that the first challenge of self-improvement is knowing yourself. Fundamentally, the whole topic’s premise—that humans may be self-unaware, and justifying irrationality with quirks (dimyonos) instead of  using seichel—is foundational to avodas hamussar.

Combating Mental Blind Spots

I doubt many behavioral economists  recognize it, but some of their key tips for overcoming mental biases could have come straight from the Mesilas Yesharim. Combating mental blind spots begins with awareness of our shortcomings and a focus on where we may be fooling ourselves (zehirus). Behavioral economists also strongly recommend predetermination (i.e., kabbalos), such as deciding on future investment buy/sell points in advance. Investors can draft an investment policy statement stating what they will do to rebalance a portfolio during market crashes or booms. Defaulting to predetermined plans, made when emotions were cool, helps prevent irrational, instinctive decisions.

Asei Lecha Rav u’Knei Lecha Chaver

To minimize emotion-driven errors, even professional money managers sometimes will hire a colleague to manage their own money. At a minimum, they’ll run major financial decisions by others to help ensure they’re not getting tripped up by passion or poor logic. The final behavioral economics tip for Simcha is to seek advice and second opinions from knowledgeable advisers and friends. Again, sounds familiar? Clearly, following the lessons of mussar and Pirkei Avos offers benefits in all realms, including financial.


Want to dig deeper?

Try these related articles

It’s All Relative: Training Your Brain to Gain

Do You Have What It Takes to Be Your Own Investment Advisor?

Investment Risk Versus Reward: Navigating the Complex Relationship

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