How to Avoid Ego Traps

Our Ego makes us perceive reality in a distorted way, which can lead to wrong investment decisions

I remember during the big Bitcoin hype in November 2017, when the mood in the Bitcoin and Altcoin market was very optimistic one of my friends invested in Bitcoin. He was convinced that the Bitcoin price would rise far above $20,000 and could also give plausible reasons for this. Half a year later, after the Bitcoin price had collapsed to about $8,000, I met him again and we talked about his investment. He said that he knew that the Bitcoin price would never rise above $20,000 and again he gave me plausible reasons for this.

He did not notice it himself, but I could still remember the situation at the time, how he told me with conviction and enthusiasm about the reasons why the Bitcoin price would go up so high. He was subject to the so-called back-shooting error, one of the most dangerous traps in investment decisions.

Trap 1: Hindsight Bias

The hindsight bias, also known as the “I knew it all along” effect, is a widespread danger for investors. It is the tendency of people to believe in retrospect that they knew something they did not know. This means that when we know the result and remember it, we are reproducing a distortion of the real result. This regression error is a cognitive illusion. The human mind has a deficient ability to reconstruct past states of knowledge or beliefs that have changed. Once you have a new view of things, you lose the ability to remember what you believed before you changed your mind.

Many psychologists have studied hindsight bias to find out what happens when we change our mind. When an event actually happened, respondents overestimated the probability they had previously attributed to the event (“I knew it all along”). If an event did not occur, they incorrectly remembered that they had always considered it unlikely. Further experiments showed that people not only predicted the accuracy of their own earlier ones, but also overestimated the accuracy of others.

The hindsight bias is a very strong effect. It also occurs when we know about the hindsight bias. We erroneously remember wrong facts when we remember our trades or investments at a later date. We overestimate the probability when an event really occurs and we underestimate when an event has not occurred. For example, in retrospect we think that we have always correctly predicted the price, but this is usually not true. We only remember it wrongly.

Trap 2: Outcome Bias

Back to my friend and his investments: He made a loss when he invested in the hype back then. He bought in at a Bitcoin price of about $14,000 and held his positions long after the price had collapsed after the hype. When we talked about this investment, he said it was a bad investment. But that was not quite true, because after he bought in, the price went up to almost $20,000. Unfortunately, he missed to exit in time. By judging whether it was a good or bad decision, he committed the so-called “outcome bias”.

Outcome bias is the tendency of people to judge a decision by its final outcome rather than by the quality of the decision at the time of the decision. So, we judge our trades and investments at the end when we have realized a loss or a profit. This is an outcome bias, because we actually have to judge whether the decision at the beginning of the trade or investment was good or not.

Not every loss trade was a bad decision and not every profit trade was a good decision. In the evaluation, the hindsight bias exerts a damaging influence. It causes one to judge a decision by its outcome rather than judging whether the decision-making process was good. If the results are bad, investors think that the decision was bad, and they did not see the signs. However, they forget that these signs only became visible afterwards. Some investments that sounded reasonable in advance may appear negligent in retrospect. The worse the consequences, the greater the hindsight bias. Conversely, investors who were lucky are rewarded and not punished for taking disproportionately high risks. Instead, it is believed that these investors had the intuition and foresight to predict success. In retrospect, those who doubted these investors are then judged to be cautious and weak. Some fortunate ventures can then surround a ruthless investor with a halo of foresight and boldness.

Investors often believe they have understood the past and that the future can be predicted and controlled. Unfortunately, this is often an illusion. These illusions are reassuring, they reduce our fear if we are aware of the uncertainty of the future. We all strive for the reassuring message that our actions have the desired consequences, and that wisdom and courage are crowned with success.

Test and Train Yourself now:
Write down today’s rate of the cryptocurrencies in which you want to invest or have already invested. Now make an estimate of where the exchange rate of all cryptocurrencies will be in exactly 6 months. Also, document why you believe that the exchange rate will be exactly there. What information or factors have you used for your estimate? Document as precisely as possible! Put a reminder in your calendar and check the reality with your forecast in 6 months.

This task leads to the painful insight that we are almost always wrong with our predictions – although in retrospect we like to claim the opposite (hindsight bias). The only way to avoid the outcome bias is to keep a diary of our trading and investment decisions and to document everything that led us to this decision. After some trades and investments, we can evaluate which original decisions led to which result and adjust our strategy accordingly without committing the outcome bias.

Trap 3: The WYSIATI Rule

WYSIATI stands for “What you see is all there is”. Daniel Kahneman found that our brain only processes the information currently available. He says that we make our intuitive, hasty conclusions based on this limited database. He calls the intuitive, fast-thinking system in our brain System I. It makes us insensitive to the quality and quantity of information. The presentation of only one side of a story has a strong effect on our judgment.

Test subjects were given one-sided information and they were also told that it was one-sided information. Although the test subjects were given the opportunity to get a picture of the other situation (activation of System II), they did not do so. It is also interesting that people who only have one-sided information are much more confident in their judgement than people who have a picture of both sides.

The consistency of the information from which we construct a story is more important to us than the completeness of that information. The strength of our inner conviction of a matter, therefore, depends on the context of the story we construct from the available information. If we know little, it is easier to put together this little information into a consistent story than if we know a lot. This is why WYSIATI also makes sure that we do not take more information or we might spoil our story.

Regarding our investments, this means that we only get as much information as we need for a coherent story, that can be logically explained to us. We also feel secure in our judgment. In short, we often make investment decisions based only on the information currently available. We do not think about the things we do not know.

by Wolfgang Fallmann