Psychology of Successful Investing

The problem of how to maximize growth of wealth was solved over half a century ago by Kelly and Breiman: maximize the expected value of the logarithm of wealth after each period. However, as living organisms we have evolved to maximize gene replication, not wealth. Natural selection is a slow process, so our minds today are adapted to seeking our ultimate goal of reproduction in the environment of evolutionary adaptedness (EEA), which roughly coincided with the Pleistocene. In order to reproduce, or assist with the upbringing of close relatives, individuals are motivated to survive for as long as possible. Any living person may ruminate: I have survived thus far, everything that I have already experienced cannot be fatal because I am alive. For example, I have never eaten that berry before, and I have survived, so why should I risk eating it now? The most fundamental bias, therefore, is the status quo bias (also known as conservatism). The status quo bias can lead to another cognitive heuristic, known as anchoring, which describes the common human tendency to make decisions based on an initial ‘anchor’. We prefer relative thinking to absolute thinking. Anchoring can cause the stock market to underreact to fundamental information. The endowment effect is the phenomenon in which people value a good or service more once their property right to it has been established. Living in groups meant that respect for private property would have likely evolved as a Nash equilibrium, and the evolution of private property may well have given rise to the endowment effect. The idea of loss aversion is that losses and disadvantages have a greater impact on preferences than gains and advantages. Loss aversion and risk aversion are both consequences of the status quo bias/endowment effect. There is a further justification for risk aversion. Reproduction is a multiplicative process, so it is the logarithm of population that is additive. If one is risk neutral in terms of log(population), because the log utility function is concave, it follows that one must exhibit a small degree of risk aversion regarding population. In other words, it is better to have 4 offspring rather than (2 or 6), thus justifying risk aversion for gains. Further, as the subjective Bayesian de Finetti famously noted, ‘probability does not exist’, but we prefer to assign a subjective probability with ease. In other words, we also exhibit a preference for known risks over unknown risks. This is known as ambiguity aversion. Note