Issue No. 45
Investing is managing risk under uncertainty. And it’s under those conditions that we sometimes reach for mental shortcuts that end up derailing us.
This week’s guest is Barry Ritholtz, whose book How Not To Invest both informed and entertained me when I read it over the summer. It then inspired me to do this crossover issue about seven cognitive biases that can show up in investing.
Barry and I crossed paths many years ago when I first released the Book of Bad Arguments online. I remember seeing an uptick in visitors one day, and when I checked to see where they were coming from, they were from Barry’s website.
I’ve included a summary below of the cognitive biases we covered, with added exposition for the ones we didn’t get to, but which are still relevant to investing.
You can watch the full conversation by tapping the play button above. The video will also be posted to YouTube. I hope you enjoy it.
Understanding what it is I do not know is a core part of my approach to the world. It’s why I focus so much on investor psychology and cognitive issues. I want to understand what I don’t know, and when my brain is lying to me. My experience has found this approach to be rewarding.
Summary of key takeaways
1 Dunning–Kruger effect
This bias shows up when people with little experience overestimate their ability,1 while true experts, who understand how complex a field really is, often underestimate themselves. In investing, that blindspot can be costly.
Barry: Your ability to evaluate your own skillset is in and of itself a discrete skill. People who are experts actually tend to underestimate themselves, while people who just started out have an attitude of, Well, how hard can this be? Like, I know that guy, he’s successful in that space and I don’t think he’s very smart. So if he’s successful—despite the fact that he’s put in 20 years of practice and honed his craft and what have you—I think I could blunder into trading options.
The entire concept of gambling in Vegas is based on the fact that people are innumerate and overconfident.
2 Confirmation bias
Instead of seeking out evidence that disconfirms our views, we tend to look for proof that confirms what we already believe. In investing, that can lead us to cling to a decision, a position, or a forecast even though the world is messy and full of randomness. Barry argues for thinking probabilistically—mapping out best, worst, and middle-case scenarios—rather than treating the future as binary.
Barry: When you have a position you believe in, there’s always information out there to confirm it. The beauty of debate, or of things like moot court2 in law school, is you legitimately don’t know which side you’re arguing for. When I write about markets, I frequently write about trying to assess the world in a probabilistic framework, rather than, I think this is what’s going to happen next and you’re either right or wrong. The reality is so many random things can happen between now and six months to a year from now that those forecasts are almost always destined to fail.
3 Survivorship bias
We often draw conclusions from what we see without realizing what’s missing from the picture. Fund companies in the 1990s typically reported only surviving funds, leaving out those that were liquidated or merged away often due to poor performance. Once those failures are included, the average performance looks very different.
We also see survivorship bias in how pundits are remembered. A forecaster may be celebrated for “calling the crash,” but people conveniently forget the ten years of failed calls that came before. Media often amplifies the hits and erases the misses, giving us a distorted picture of skill.
Barry: Survivorship bias dates back a long time, but the famous example is WWII bombers. You see planes returning peppered with holes in the fuselage, and the generals wanted to put armor there. Abraham Wald said, You’re looking at the planes that made it back. Where were the planes that didn’t make it back hit? That was the great reveal: if you want these planes to be survivable, put the armor where the bullet holes aren’t because they can live with where those bullet holes are, and they can’t live where with where the bullet holes aren’t.
In the 1990s, the finance version of this is that all these fund companies were advertising these mutual funds and they’re all outperforming. Most of them are outperforming their benchmark and that’s pretty fascinating. And some were asking, how come, you know, it feels like my investments aren’t outperforming.
So people were constantly rolling from one fund to the one hot fund. And somebody does a study and they say, This is classic survivorship bias. You’re seeing the funds that are still around. What about all the myriad funds that closed or were merged into other funds or underperformed, lost capital, had clients leave? Once you put those back into the data set, suddenly, the average fund is not outperforming.
(See issue no. 2 for more on survivorship bias.)
4 The endowment effect
We tend to overvalue what we own simply because it’s ours. During the housing bubble, many homeowners clung to peak prices even as the market shifted under their feet. The effect wasn’t just psychological—it delayed decisions, distorted expectations, and left people anchored to valuations that no longer existed.
Barry: I have a vivid recollection of speaking to a bunch of neighbors before the stock market crashed, there was like a year or two in between where people were unaware that the game was already over for real estate. And I remember having conversations with people about selling their house.
And it’s like, Bob down the street, his house isn’t as nice, we have a nicer yard, we have a new kitchen. He got a million dollars. How come I’m only being offered $800,000?”
It’s like, he sold his house two years ago right into the peak of the bubble, whereas you’re on the other side of the bubble. So as much as your house is nicer, his timing was better. They’ll say, I think my house is worth a million dollars. I go, “It is, you just have to get a time machine and go back to ‘05 and sell it to people then.”
(See issue no. 44 for more on the endowment effect.)
5 The sunk cost fallacy
We might buy shares of a company at $100 each, convinced it’s a solid long-term play. Over the next year, the stock falls to $40 because of deteriorating fundamentals like shrinking market share, rising debt, and poor management decisions. Instead of reassessing, we might think to ourselves, I’ve already put so much money into this stock, I can’t sell now. I need to wait until it gets back to $100 so I can break even.
A rational decision would be based on the current outlook: is the company at $40 a good investment relative to other opportunities available today? By holding to make back the original $100, we’d be letting past costs dictate our future choices.
You have paid [for a stock or fund you own] … you invested time and money into it. You should not stay married to a holding simply because of those already incurred expenses. Of course, this is not how most people behave.
—How Not to Invest
(See issue no. 13 for more on the sunk cost fallacy.)
6 The hindsight bias
It’s easy to look back and go, Oh, it was obvious stocks were going to bounce back after COVID. But back in March 2020, can we be sure we actually felt that way? The hindsight bias tricks us into believing we were always on the right side of calls like those even though we might not have been at the time. It’s the false sense of I knew it all along that can fuel overconfidence and riskier bets in the future.
Given what you know in 2025, you [tell yourself you] were cautious in 2008-09! Once you know what happened, you cannot recall ever not knowing. Your memory combines what you know today and what (you imagine) you knew then.
—How Not to Invest
(See issue no. 14 for more on the hindsight bias.)
7 The halo effect
A tech founder starts talking about which stocks they’re buying. Investors flock to copy their trades, thinking, If they can build a billion-dollar company, they must know which stocks will do well. The founder’s proven ability in building companies creates a halo that makes people assume they’re also good at this other thing—stock picking. In reality, the two skills aren’t the same. The halo effect can get us to place extra weight on who is saying something rather than what the evidence shows.
8 Advice for someone who’s new to investing
Barry closed our conversation with three rules for anyone starting out:
Know your purpose. Investing without clear goals leaves you exposed to the wrong risks.
Start with a broad, low-cost index. Make that your core holding, then decorate around the edges if you need more excitement.
Stay out of your own way. Let compounding do the heavy lifting, and don’t let your lizard brain derail long-term growth.
Barry: Know your purpose. Figure out the purpose of the investments you’re making. What are you saving for? Are you saving for a house, to pay for college, to pay for retirement? When you know what you’re saving for, it gives you a range of how much risk you want to take. And the reason that’s important is risk and return are two sides of the same coin.
Start with a broad index. You want to be a long-term investor and the best way to do that is with a low-cost index. I like to use the example of a Christmas tree—it’s got ornaments and garlands and lights. The tree is your core index (60–70%). All the decorations are everything else around it.
Stay out of your own way. The last thing is just behavior: stay out of your own way. And the line I write in the book is, my job is to prevent my big dumb lizard brain from interfering with the markets compounding. If you just buy something like the S&P 500 and leave it alone for 40 years, $10,000 becomes two or three million dollars. The longer you can let markets compound in your favor and not interfere with it, the better off you are.
Truth never triumphs—its opponents just die out. Science advances one funeral at a time.
—Max Planck
Until next time.
Be well,
Ali
P.S. Some past issues to read through in case you missed them.
https://en.wikipedia.org/wiki/Dunning%E2%80%93Kruger_effect
https://en.wikipedia.org/wiki/Moot_court
