5.1 - Systems and Psychology - How to be a better investor

We're wired to naturally be bad investors. Here are the big cognitive biases we have and how to spot them

What You Know vs What You Do

“Investing is simple. But not easy.” — Warren Buffett

In 2024, the independent research firm Dalbar released its Quantitative Analysis of Investor Behavior — a long-running study of how real people actually invest.

Between 1993 and 2023, the S&P 500 returned an annual average of 10.15%.

But the average investor in that same index?
Just 8.01%.¹

Let’s break that down:

• A £10,000 investment, left untouched, could have grown to £181,775.

• But the average investor only made £100,906.

That’s a 45% underperformance — on the same investment.

So what happened?

We did.

The Brain - the enemy of sound investing

We are not wired to be good investors. Investing itself is a very recent human activity, and the cognitive biases we have to deal with life are not suited to dealing with the two main main emotions that move markets:

• 🔥 Fear

• 🚀 Greed

Markets are Emotional

Markets swing wildly in almost irrational ways based on these two emotions.

• When people are fearful, having lost a little, they sell to avoid losing more. That’s why market crashes can be so deep and punishing.

• When things are going well, people will get greedy and buy, to avoid missing out on more gains. That’s why market bull runs (when the price goes up) can seem to go on forever without any financial or economic justification. It’s just greed.

These two emotions play right into the hands of the 4 main cognitive biases which can hurt us the most. That’s why:

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves”

Peter Lynch

Common Cognitive Traps

Loss Aversion

We feel the pain of a loss twice as strongly as we feel the pleasure of a gain.
That means a £500 drop hurts more than a £500 gain feels good — so we’re far more likely to make emotional, fear-based decisions when prices fall.

This is why many investors sell at the worst possible time: not because they’ve lost money — but because they can’t stand the feeling of losing money.

And by doing that, they crystallize their losses, rather than waiting for them to recover.

Worse still, they stop buying when they should be filling their boots with great value assets at discount prices

Recency Bias

We assume that whatever just happened will keep happening.

• If markets have been rising, we believe the good times will continue forever.

• If they’ve been falling, we brace for the worst — even if the fundamentals haven’t changed.

This leads us to buy when things “feel safe” (i.e. expensive), and sell when things “feel dangerous” (i.e. cheap).

This is the exact opposite of what actually works.

Things can’t go up forever. What goes up must come down, that is the time to sell.

when markets crash - that’s when high quality assets are being sold cheaply, and it’s time to buy.

Unfortunately, our brains lead us to behave the other way around.

Confirmation Bias

We’re wired to seek out information that supports our current beliefs.

If we feel nervous about the market, we notice scary headlines.
If we feel optimistic, we latch onto bullish tweets or talking heads.

Instead of challenging our emotions, we go looking for proof that we’re right - and usually find it.

And no successful investor has ever been quoted as saying “invest with your gut, it always works”.

Herding

When everyone is selling, it feels smart to sell.
When everyone is buying, it feels foolish not to.

But markets reward patience, not popularity. Following the herd might feel safe - but it often leads to the same fate as the herd: buy high, sell low. Lose money.

Awareness First

You can’t delete these biases — they’re baked into how our brains work.

But if you can name them, you can start to catch them.
And if you can catch them — you can stop them from running the show.

Systems beat Willpower

It’s very hard to break bad habits using willpower alone. Just ask any smoker or addict.

But they are even harder to beat when they are wired into us.

That’s where systems can help. Willpower can break under stress. But a good system, which is automatic, and unemotional, can ride the waves of the market and sail you safely through the storms.

Emotionally bull runs and crashes can feel painful. But the goal is not to feel nothing. It’s to be disciplined despite the feeling.

Next, we’ll look at some of the systems that can build better investing habits, and maybe close the Dalbar gap.

Recap

• Most investors underperform the market - not because of bad choices, but bad reactions.

• Our brains are wired to panic, follow the crowd, and feel pain more than gain.

• Four key traps: Loss Aversion, Recency Bias, Confirmation Bias, Herding.

• You can’t fight your brain with willpower - but you can build systems to work around it.

Up Next: Dollar Cost Averaging - How to not time the market perfectly

How you can even make money during market crashes without thinking about it

1. https://osbornepartners.com/wp-content/uploads/2024/04/20240-Why-Typical-Investors-Underperform.pdf

Disclaimer: This content is for informational and educational purposes only. It does not constitute personal financial advice. Everyone’s situation is different — if in doubt, speak to a qualified, regulated financial adviser.