By: Dividend Sensei
This isn’t surprising because no less than Warren Buffett, the greatest investor in history (20+% total returns for over 65 years) has said that getting rich in the market isn’t about raw intelligence but having good emotional intelligence. “You don’t need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with a 130 IQ. Rationality is essential. What you do need is emotional stability…You have to be able to think independently.”
This means avoiding fall prey for the inherent psychological pitfalls all people have, including recency bias, and loss aversion. Loss aversion is a behavioral finance principle discovered by Amos Tversky and Daniel Kahneman. Their studies found that it hurts twice as much to lose a dollar, as to gain a dollar. When coupled with recency bias, this helps to explain the famous market bubble/crash cycle as pictured above.
Recency bias simply means that humans are predisposed to thinking that recent trends will continue, sometimes indefinitely (stocks only go up). This is why even highly intelligent and otherwise rational people can get sucked into bubbles. Or to put another way, even smart people can play the “greater fool” game. That’s where you knowingly buy a stock that’s overvalued, precisely because its been going up so strongly. You assume the momentum will hold, and that a greater fool will pay you more for your shares when you smartly exit before the top is reached. Of course that’s before the bubble bursts and remaining shareholders lose their shirts.