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Executive summary
- Why are we so bad at handling money?
- For the longest time, our brain did not evolve to understand money.
- That is not a problem as we can learn skills in order to build wealth.
- What can we learn from rich people?
- Either invest or start a business.
- Reinvesting into assets builds wealth.
- The ability to understand and handle risk is crucial.
- What can we learn from psychology?
- Cognitive biases have a big influence on our behavior in financial contexts.
- Cognitive biases are systematic patterns of deviation from rationality in decision-making, for example:
- The confirmation bias is the human tendency to confirm our existing beliefs.
- The sunk cost bias describes irrational spending to existing investments because of resources used in the past, regardless of the current prospects.
- The overconfidence bias is the human tendency to overestimate our own abilites.
- Loss aversion describes the tendency to prefer avoiding losses over acquiring equivalent gains.
- It is impossible to avoid being influenced by cognitive bias, but we can take actions to mitigate its influence.
- Being unaffected by others and your emotions can help to make better investment decisions.
- The Fear & Greed Index provides insights to market sentiments.
- Should you aim for prosperity or wealth?
- Prosperity is more holistic than materialistic wealth.
- What helped me?
- Becoming an investor is very easy and you can decide what degree of engagement is right for you.
- Do not forget there are people with less skills out there that make a living off investing.
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Why are we so bad at handling money?
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For the longest time, our brains did not evolve to understand money.
- Humanity is around 200,000 years old
- Money was invented around 3,000 years ago
- Until the 21st century, not even half of the world population had access to a bank or mobile payment provider
- Until today, 31% of the global population does not have acces to a bank or mobile payment provider
—> Understanding money was never necessary for survival!
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It is possible to learn how to handle money.
- To express it in the words of Charlie Munger:
I constantly see people rise in life who are not the smartest, sometimes not even the most diligent. But they are learning machines. They go to bed every night a little wiser than they were that morning.
This means that we can become successful at handling money if we learn how to do so!
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What can we learn from rich people?
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Either invest, or start a business.
- Very few people get rich by renting out their time.
- It is way more likely to get rich by investing or starting a business.
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Reinvesting in assets builds wealth.
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The ability to understand and handle risk is crucial
- Any investment opportunity out there has a certain risk of failure.
- If any opportunity can fail, most opportunities can also succeed. However, we can never be sure which opportunities that will be. But the more opportunities we take, the higher our likelihood of succeeding becomes.
- Additionally, there’s a very interesting thing about a lot of Investments: the loss domain is mostly finite but the game domain is often infinite. For example, the worst thing that can happen to the stock we own is for the company go bankrupt and we end up with devalued stock. We lose anything we put in to the stock. But at the same time, this is not true for the other side. Companies can easily double, triple, or in tenfold which is a normal thing to happen in the stock market.
- This results in the following take away: As long as you're right sometimes, you can be wrong often.
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What can we learn from psychology?
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Cognitive biases are systematic patterns of deviation from rationality in decision-making and can have a big effect on financial decisions.
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Confirmation bias
- Confirmation bias refers to our tendency to favor information that confirms our existing beliefs or hypotheses while disregarding or downplaying contradictory evidence.
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- Overvaluing confirming sources when performing due diligence for an investment
- Ignoring information about investments which is contrary to existing beliefs
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Sunk cost bias
- The sunk cost bias refers to our tendency to continue investing in a project or decision simply because we have already invested significant resources (such as time, money, or effort) into it, regardless of its potential future benefits or outcomes.
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- Not considering opportunity costs when putting more money into a struggling investment
- Example of the Concorde
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Overconfidence bias
- Tendency to overestimate one's abilities, knowledge, or the accuracy of judgments and forecasts
- Prevalent for all humans, but men are affected most
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- Overconfidence leads to excessive and risky trading
- Especially dangerous since security measures are felt to be unnecessary
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Loss aversion
- Loss aversion is a cognitive bias that refers to our tendency to strongly prefer avoiding losses over acquiring equivalent gains
- Example & experiment:
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- Stocks are avoided for irrational reasons due to possibility of short term loss
- Investors tend to choose investments which are safer than necessary for their investment horizon
- Investments are not sold when they are in the loss domain, but sold too quickly when in the gain domain
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We can take action to mitigate the influence of cognitive bias when investing:
- Increase self awareness & understand that it is impossible to be unaffected by cognitive bias.
- Educate yourself and learn about different cognitive biases.
- Conduct thourough research before investing & include actively looking for alternating opinions to your due diligence routine.
- Seek independent judgement, e.g. from investment forums, independent financial consultants or critical investors you know.
- Diversify your investments and do not put all eggs into one basket, this way biases only harm you to a limited extend.
- Review and reflect previous investment decisions and scan for mistakes, even if they turned out positively.
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Emotions in investing
- Being unaffected by others & your emotions can help to make better investment decisions
- It is crucial to form an independent judgement
- You should not follow the sentiment of others, as a simple rule of Warren Buffet summarizes:
- CNN provides an index which displays the current market sentiment:
- You can access the index here
“You want to be greedy when others are fearful. You want to be fearful when others are greedy. It's that simple.”
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Should you aim for prosperity or wealth?
- Prosperity is more holistic than materialistic wealth
- Prosperity is characterized by the three F´s:
- Family and friends, i.e. social ties. Nobody can live prosperous if they are lonely.
- Fitness, both physical and mental. Money is meaningless if we are sick or unfit to make use of it.
- Freedom is crucial to live in prosperity. If we cannot live in a free country or are persecuted, prosperity is not given.
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Personal ideas which might be helpful for you.
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Key takeaways
1. Humans are bad at handling money by default.
2. (Re-)investing into assets makes you rich in the long run.
3. Be aware about cognitive bias when investing.
4. Don´t let the masses influence your emotions.
5. Prosperity is more holistic and important than wealth.
6. It is easy to become an Investor, anybody can make it.
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Sources
Please refer to the powerpoint file for the exact relationship of contents to sources!
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