002 Cognitive Bias: Mental Accounting

Notes from Think Like the Great Investors by Colin Nicholson:

New investors are always looking for a guru or a perfect system to tell them what to invest in. This is flawed because no system is perfect all the time and nobody knows their investment needs better than themselves. The path to successful investing lies within us.

The world is hugely complicated. One way of dealing with the complexity is to put things into categories. This simplifies things by breaking them down into simpler parts. We do this with budgetting, but putting money into categories or accounts makes us see it differently, even though one dollar is the same as any other.

Some people identify some of their funds as “money I can afford to lose” in fact, it is no less valuable than money they can’t afford to lose, but they treat it differently to rationalise bad investment behaviour. When we are up, we consider it ‘the market’s money’ and use that as an excuse not to sell, taking more risk than we would if the stock fell straight after buying. An example is where an investor has bought a stock at $1 and it rises to $2. He will say that he has made $1 profit. If the stock later falls by 20c, he will say that he made 80c profit. In fact he has lost the 20c he would have made if he sold the stock when it was trading at $2.

Your paper profits are real money and you need to protect them as much as if it is money in the bank.

Some strategies to overcome mental accounting are:

  • Revalue each stock at its current price, forget about the price you paid for it.
  • Restart your records each year.
  • Plot the value of your portfolio on a chart so you can see what level it has reached.
  • Take some profit off the table.
  • Write a six monthly report on your portfolio’s performance.
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