Why You Never Learn From Your Investment Mistakes

Study successful investors, and you'll notice a common denominator: They are masters of psychology. They can't control the market, but they have complete control over the gray matter between their ears.

And lucky them. Most of us, on the other hand, are mental catastrophes. As investor Barry Ritholtz once put it:

You're a monkey. It all comes down to that. You are a slightly clever, pants-wearing primate. If you forget that you're nothing more than a monkey who has been fashioned by eons on the plains, being chased by tigers, you shouldn't invest. You have to be aware of how your own psychology affects what you do.

Take one of the most powerful theories in behavior psychology: cognitive dissonance. It's the term psychologists use for the uncomfortable feeling you get when having two conflicting thoughts at the same time. "Smoking is bad for me. I'm going to go smoke." That's cognitive dissonance.

We hate cognitive dissonance, and jump through hoops to reduce it. The easiest way to reduce it is to engage in mental gymnastics that justifies behavior we know is wrong. "I had a stressful day and I deserve a cigarette." Now you can smoke guilt-free. Problem solved.

Humans are one of the only creatures that engage in this self-deluding behavior. In their excellent book Mistakes Were Made (But Not By Me), Carol Tavris and Elliot Aronson write:

A dog may appear contrite for having been caught peeing on the carpet, but she will not try to think up justifications for her misbehavior. Humans think; and because we think, dissonance theory demonstrated that our behavior transcends the effects of rewards and punishment and often contradicts them.

Yes, when it comes to learning from bad behavior, you are at a disadvantage to an incontinent puppy.

Cognitive dissonance is especially toxic in the emotional cesspool that is managing money. Raise your hand if this is you:

You criticize Wall Street for being a casino while checking your portfolio twice a day. You sold your stocks in 2009 because the Fed was printing money. When stocks doubled in value soon after, you blamed it on the Fed printing money. You put $1,000 on a hyped penny stock your brother convinced you is the next Facebook. After losing everything, you tell yourself you were just investing for the entertainment. You call the government irresponsible for running a deficit while simultaneously saddling yourself with an unaffordable mortgage. You buy a stock only because you think it's cheap. When you realize you were wrong, you decide to hold it because you like the company's customer service.

Almost all of us do something similar with our money. We have to believe our decisions make sense. So when faced with a situation that doesn't make sense, we fool ourselves into believing something else.

Worse, another bias -- confirmation bias -- causes us to bond with people whose self-delusions look like our own. Those who missed the rally of the last four years are more likely to listen to analysts who forecast another crash. Investors who feel burned by the Fed visit websites that share the same view. Bears listen to fellow bears; bulls listen to fellow bulls.

Before long, you've got a trifecta of failure: You make a bad decision, rationalize it by fighting cognitive dissonance, and reinforce it with confirmation bias. No wonder the average investor does so poorly.

Great investors are different. They are practically allergic to these biases.

Value investor Mohnish Pabrai has an outstanding long-term track record, but he spends an inordinate amount of time analyzing his mistakes.

In an interview last year, Pabrai told me about his response to 2008, when he (and nearly everyone else) lost a lot of money. Rather than rationalizing his poor performance by blaming Wall Street, he set out to learn from what were, after all, his investment decisions. "I clearly studied my own mistakes, and I went back systematically and documented why we lost money on these different investments," he said. Studying his mistakes eventually led to a checklist Pabrai now consults before making new investments. "The checklist significantly brought down the error rate," he said.

Most investors don't think like this. Which is why Pabrai outperforms most investors.

Billionaire Ray Dalio is similar. His hedge fund, Bridgewater Associates, has a policy that every employee must always speak their mind, even if it means telling a superior they're wrong.

"Successful people ask for the criticism of others and consider its merit," Dalio writes in his employee handbook. "Remember that your goal is to find the best answer, not to give the best one you have."

Most investors don't do this. They assume their opinion (or the opinion of those who agree with them) must be right, and will delude themselves into justifying a belief when shown opposing facts. Dalio doesn't put up with this behavior -- which is part of why he's a billionaire, and you and I are not.

"The brain is designed with blind spots," Tavris and Aronson write, "and one of its cleverest tricks is to confer on us the comforting delusion that we, personally, do not have any." Alas, you do. And they're preventing you from becoming a better investor. Fight them as hard as you can.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.