How to learn from your investing mistakes

Australia has a divorce rate of around 40%. Yet ask any newlyweds what the odds are that their own marriage will end in separation and their estimate is usually just shy of zero. 'Remarriage is the triumph of hope over experience', as author Samuel Johnson put it.

We all like to think of ourselves as perfect realists, but the truth is that we often suffer from what psychologists call optimism bias: the tendency to overestimate the probability that good things will happen to us and underestimate the risk of adverse events.   

Why do we maintain such a rosy outlook and what are the implications for investing?

In 2011, psychologist Tali Sharot published research that suggests it all comes down to a preference for positive information when forming memories. We tend to remember things that turned out better than expected and quietly sweep under the rug anything that didn't live up to our predictions.

Sharot asked participants in the study to estimate the probability that they would suffer 80 different adverse life events, such as Alzheimer's disease, robbery or getting cancer. They were then told the real-world probability of those events. Finally, in a later session, they were asked to recall the probabilities.

It turns out that the participants' second guesses were more accurate when their first guess was overly pessimistic. That is, they were more likely to learn from information that offered the chance to adopt a more positive outlook than data that challenged their overly hopeful expectations.

When an investment doubles, we take note and try to figure out what we did right so as to find the next opportunity. But when one of our stocks halves in value, we either look for someone else to blame or just sell and put the whole messy experience behind us. Very few investors track the subsequent return of stocks they've sold.

However, the only way to know whether it was a good idea to sell the stock and replace it with a new one is to track how both stocks do after your decision.     

The antidote to optimism bias is pretty simple: keep an investment journal. At the time of purchase and sale of any stock, make a quick note of your reasoning to reflect on down the track.

Failures are inevitable in investing. Take pride in them and force yourself to study your mistakes otherwise optimism bias will creep in and remove some of your best opportunities to improve.

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