Hot-cold-empathy gap

Have you ever asked yourself this:

How can I control myself when I feel the irresistible need to break my rules about how to invest in the stock market?

That question pertains to the “hot-cold-empathy gap”, where we say to ourselves in a calm (= cold) moment:

“The level of risk that I want to take is bound on one side by gains of up to 15 percent and on the other, by losses up to 10 percent”.

Nevertheless, when we lose 5 percent of our money, we panic (= hot) and we sell everything!

When we view such cases, we usually think that the colder, more rational voice in our head (that set up the initial risk level and portfolio choice) is the correct one, whereas the voice that panics—while reacting to short-term market fluctuations—is the one that causes us to stray. Bias: Hot-Gold-Empathy Gap

From this perspective, there are two types of solutions available:

The first is to get the “rational” side of ourselves to set up our investment in such a way that it would be difficult for our emotional self to undo it in the heat of the moment.

For example, we could seek the help of our financial advisor that unless we have slept on the decision for 72 hours (this could have helped a lot during the recent Black Monday phase), or that unless there is a document to be signed—for any changes to be made—by ourself and our significant other, no changes  to our investment would be made.

Alternatively, we could attempt not to awaken our emotional self by not looking at our portfolio that frequently, or we could ask our financial advisor to alert us—only—if our portfolio has lost more than our indicated acceptable amount of loss (of course we know that it takes money to make money and that stocks markets don’t go up in a straight line).

Regardless of what we do, I think that the freedom to do whatever we want and to change our mind about our investment system at any point is the shortest path to bad decisions.

We really should be thinking more—and doing less—which actually applies for just about everything nowadays.

While limiting our freedom to act often goes against our ideology, sometimes limiting our ability to make decisions is the best way to guarantee that we will stay on our intended long-term path, our master plan that includes our thoughts on the known knowns, the known unknowns, and the awareness that there are unknown unknowns.

You are right, that was quite a mouthful.  The American statistician and author Nate Silver explains the “unknown unknowns” this way:

“If we ask ourselves a question and can come up with an exact answer, that is a known known.  If we ask ourselves a question and can’t come up with a very precise answer, that is a known unknown.   An unknown unknown is when we haven’t really thought to ask the question in the first place.

An unknown unknown is a contingency that we have not even considered.  We have some kind of mental block against it, or our experience is inadequate to imagine it; it’s as though it doesn’t even exist.

To articulate what you don’t know and to think of the world in probabilities is a mark of progress.” 

 

I am convinced that avoiding catastrophic mistakes matters more than constructing the “perfect portfolio”.

And while I am at it, I need to constantly remind myself that it’s easier to recognize other people’s mistakes than my own!

 

“There may be nothing across the entire spectrum of human endeavour that makes so many smart people feel so stupid as investing does.” — Morgan Housel

“It’s impossible that the improbable will never happen.” — Emil Gumbel (German Statistician)

One Comment

  1. It’s strange how limiting options and abilities can actually help to restrain bad behaviour and generate a better outcome! I remember reading a study how a group of investors who had access to market news performed worse than another control group of investors who didn’t know what was going on!

    The ending quote by Emil Gumbel is golden!

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