5 Jan '19

Why Smart People Make Bad Decisions

I recently read the book summary of Big Mistakes by Michael Batnick. The book has an interesting subtitle: The Best Investors and Their Worst Investments. Interesting combination, isn’t it? It contains story after story of how very smart people made bad decisions in investing.

But how could that happen? How could these smart people make bad decisions?

In essence, what happened was that they failed to manage their risks. They didn’t prepare themselves for the worst things that could happen. They were overconfident, thinking that good times would last forever. So, when the opposite happened, they lost a lot and sometimes everything.

It reminds me of a story that I wrote about in The Danger of Overconfidence:

Robert Shiller told the story of Irving Fisher – a Yale professor in the early 20th century – who said that the stock market in 1929 was in “permanently high plateau.” He invested heavily in the stock market but ended up losing a lot of money in the 1929 crash. Yale needed to buy his house and rented it out to him for him not to be on the street.

Did he change his view after all that happened? No. He still insisted that he was right. He borrowed money from his wealthy relatives, invested it, and lost it all.

The fact is, people tend to be overconfident. That can hinder them from making good decisions.

There is an important lesson here that I believe is applicable not just to investing but also to life in general. The lesson is this:

Manage your risks. Make sure that you can still handle the situation if it went wrong.

Here is another way to put it: Assuming that things would go wrong, can you handle them?

If your answer is no then you need to adjust your actions. You need to do what is necessary to put the risks under control.

Here are two questions to help you think about your situation:

  • What are the biggest risks in your life?
  • How can you put them under control?

Answering these questions can help you avoid costly mistakes. After all, there is no need for us to learn things the hard way.

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