The 3.4% Cost of Having an Idea
The world of personal finance provides a stark, reproducible demonstration of a profoundly costly human tendency: predictable error. Research examining individual investors who held large brokerage accounts scrutinized every transaction they made over several years, focusing on days when an individual sold one stock and simultaneously purchased another. This specific behavior signals a belief that the newly purchased stock would outperform the stock being sold. Using modern technology, analysts later checked which stock—the one bought or the one sold—performed better a year later. The results were not only striking but astonishing: on average, the stock that individuals sold did better than the stock they bought.
This systemic tendency to trade poorly carried an enormous average cost of 3.4 percent.
Average cost of an individual investor's idea due to poor trading decisions
The Flaw in the Rational Agent
Traditional economic theory rests on two major assumptions: that people are rational and that they are selfish. However, psychological research suggests these assumptions make little sense, prompting the development of behavioral economics and behavioral finance. These fields assert that economic agents make large and predictable mistakes. The 3.4% average cost of an individual investor’s idea reveals the high stakes: a failure to act rationally imposes a real, tangible financial penalty. The core of the issue is that true rationality demands broad framing—taking a comprehensive view of consequences in global terms and operating with a long horizon. The story of these investment mistakes is less about flawed financial models and more about psychological deviations from this broad, rational view.
To understand how systematic errors operate under constraints, it is useful to look beyond the financial markets and examine the concept of stability and control, drawing parallels between human willpower and foundational scientific mechanisms.
The Coherence of Control: The Control Theory Ideal
To appreciate why humans deviate from rationality, one must first understand the mechanisms designed to maintain stability, which are found universally in mechanical, biological, and cognitive systems. The field of control theory offers a strong framework for understanding human self-regulation and willpower.
The standard analogy for this control is James Watt’s centrifugal governor, invented in 1788, which is recognized as a foundational device in the history of automatic control theory. The governor’s primary function is to automatically regulate an engine’s speed. The mechanism operates through a principle called negative feedback: if the engine speed increases, weighted arms rise due to centrifugal force, which in turn closes the throttle to reduce speed; conversely, a decrease in speed lowers the weights and opens the throttle. This closed-loop system continually maintains a consistent, desired state by reducing any discrepancy between the current reality and the reference state.
In control theory applied to human behavior, individuals function similarly: they compare their current state to a desired goal state using a negative feedback loop. Any discrepancy prompts actions aimed at reducing the gap, and this process repeats until the desired state is achieved. Powers’ hierarchical control-system model further suggests human behavior is a cascade of nested feedback loops, managing everything from basic sensory signals to complex values and concepts. The essence of rationality, or the stable, long-term policy, mirrors the governor’s sustained effort to maintain its reference speed.
The Crucible of Context: The Gambler’s Narrow Frame
The profound financial error—the 3.4% cost—occurs because, unlike the precise mechanism of the governor, individuals routinely abandon broad framing for a much narrower, myopic view. This narrow framing, which characterizes most investor thinking, leads to significant and expensive errors.
One of the most destructive factors driving this narrow frame is overconfidence. Excessive trading, often called “churning accounts,” clearly expresses a belief that the investor possesses knowledge they do not actually have. Psychological research is fairly unequivocal: confidence is not a reliable indicator of accuracy. Rather, confidence is primarily a feeling about the coherence of a story one tells oneself; if the internal story makes subjective sense and is internally consistent, one feels confident in it, irrespective of the quality of the underlying information.
True expertise and valid confidence are radically different. Expertise develops only under specific conditions: the environment must be regular (possessing predictable regularities to be picked up), and one must engage in a vast amount of practice with immediate, clear, and rapid feedback. While expertise can be developed in fields like driving or poker, developing expertise in picking stocks is doubtful because the market is a highly irregular environment that lacks the necessary clear feedback loops. Therefore, the confidence experienced by many individual investors often lacks a valid basis and should not be acted upon.
This baseless confidence fuels harmful trading behaviors, particularly the disposition effect. When individuals must sell a stock, they are not neutral between winners (stocks that have gained value) and losers (stocks that have lost value). People tend to sell winners because doing so scores a “success,” providing pleasure; conversely, selling a loser requires acknowledging a failure, which causes pain. Investors effectively choose whether to inflict pleasure or pain upon themselves and consistently choose pleasure by selling winners and holding onto losers. This bad idea is a significant part of the total cost that individual ideas bear, demonstrating how emotional preferences override rational portfolio management. The consideration that should determine which stock to sell—future potential—is ignored in favor of the original purchase price, which a rational investor would treat as irrelevant.
The root cause of this emotional deviation is loss aversion. The major finding that distinguishes behavioral from standard economics is that agents respond differentially to gains and losses: the pain of a loss is felt more intensely than the pleasure of an equivalent gain. The pain of losing appears to be greater than the pleasure of winning by a factor of about two to one.
Ratio of pain from loss versus pleasure from gain in loss aversion
This disproportionate reaction causes many mistakes and is the major cause of risk aversion. For example, if offered a simple coin toss gamble where losing means losing 1,000 euros, the average person requires a potential gain of over 2,000 euros before the gamble becomes attractive. Rejecting a gamble with the possibility of losing 1,000 euros and winning 1,500 euros is common, even though it is quite irrational, especially when considering the long run.
The Cascade of Policy Failures
The irrationality in rejecting positive-expected-value gambles stems directly from narrow framing—looking at problems in isolation. A fully rational agent would have a stable policy for how to decide among many gambles, viewing them not individually but as part of a collective, long-term wealth strategy. Rejecting one small-stakes gamble, yet accepting ten of them in sequence, is absurd because life will inevitably offer many such opportunities. Individuals who manage to overcome this narrow framing, avoiding the loss-averse reaction to immediate losses, end up emotionally calmer and financially richer.
The reliance on narrow framing is also evident in widespread human problems of self-control, captured by time inconsistency. Individuals can form optimal long-term plans, such as saving for retirement or quitting smoking, but struggle to carry them out. For instance, 90% of smokers want to quit, yet 90% fail, preferring to push the short-run cost of quitting to “tomorrow”. This pattern occurs because human discounting is not exponential (consistent across time) but hyperbolic, meaning today is valued much more highly than the immediate future. This inconsistency is so severe that people sometimes use commitment devices—such as making a bet with friends that punishes smoking or taking syrup of ipecac to enforce sobriety—demonstrating they know they have a self-control problem and are willing to punish their future selves to achieve a long-term goal.
Beyond internal self-control, cognitive biases distort external reality. Hindsight bias is the tendency to view surprising past events as predictable once they have occurred. When an unexpected event happens, the immediate surprise is brief, replaced by an internal narrative that makes the event seem sensible. This exaggeration of the predictability of the world leads to the denial of the real uncertainty with which we are faced, which in turn produces irrational action.
These insights suggest that governmental and professional intervention must address internalities—the harm people inflict upon themselves due to cognitive errors—not just externalities (harm inflicted on others). The fact that policy outcomes are heavily influenced by psychological framing is best demonstrated by the effect of defaults. In one study of 401(k) plans, when the default enrollment was changed from opt-in to opt-out, the participation rate among young workers soared from 20% to 80%. This drastic change, driven by simple presentation, is inexplicable by any purely rational economic model and highlights how “nudges” can guide people toward better outcomes by leveraging, rather than fighting, their behavioral tendencies.
Practical Rationality and the Power of the Policy
The individual decision-maker is simultaneously challenged by narrow framing, loss aversion, overconfidence, and the illusion of hindsight, leading to decisions that predictably deviate from standard economic theory. The core implication is that practical rationality requires a system built to counteract these internal pressures, aligning human behavior with the long-term, broad view maintained by the control mechanism.
For investors, the key to reducing the expensive 3.4% error rate is to encourage this long-term, broad view. A rational investor would trade much less than real investors do, and would base trading decisions on future potential, not the original purchase price (which is irrelevant). Professionals, who are generally closer to rationality than individual investors, manage to achieve better outcomes by framing consequences broadly.
This is the central utility of expert advisors: not necessarily in their ability to pick investments, but in their therapeutic and educational role. The primary role of an advisor is to press people toward rationality, mainly by encouraging broad framing. This strategy should, in principle, cause people to trade less, churn less, and, crucially, to check their results less frequently. Frequent tracking of results causes emotional reactions and promotes unnecessary policy changes, which typically lead to worse outcomes.
Furthermore, good advising involves inoculating investors against the inevitable emotional fallout of losses. Anticipating regret—by discussing and accepting volatility and potential losses in advance—acts like a vaccine, reducing the severity of the reaction. Since responses to bad events (such as panic selling or buying at the wrong time) are the main reason individual investors typically do less well than the funds they invest in, managing the emotional response becomes paramount.
Ultimately, the goal is to cultivate an attitude that accepts volatility, mirroring the practicality of professional traders: recognizing that in any robust portfolio, “you win a few, you lose a few”. Just as Watt’s governor automatically maintains stability by adjusting to immediate fluctuations while maintaining a long-term goal, individuals who maintain a stable, broad policy for small-stakes decisions—resisting the urge to react myopically to every short-term gain or loss—are those who are emotionally calmer and end up financially richer.
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