Introduction
In our previous post, [How to Guarantee You Lose All Your Money (Invert, Always Invert)], we learned that avoiding stupid mistakes is much more important than trying to be a genius.
But this raises a painful question: If we all know what stupid mistakes look like—like using too much margin debt or buying unverified meme stocks—why do we keep making them?
Charlie Munger discovered the answer early in his career: our brains are biologically wired to make bad financial decisions. Munger identified 25 specific cognitive biases that cause us to make terrible errors, which he called the “Psychology of Human Misjudgment”.
Today, we are going to look at three of the most dangerous psychological traps that ruin the portfolios of aspiring FIRE (Financial Independence, Retire Early) investors, and how you can stop your own brain from making you poor.
1. The YOLO Trap: Social-Proof Tendency
Let’s start with a classic scenario in any office building. You have been diligently saving your money and investing in a boring, low-cost S&P 500 Index ETF. Suddenly, your coworker starts bragging about how he just doubled his money in three days by trading a highly volatile, obscure cryptocurrency. Then, another colleague jumps in, saying she just bought a trendy tech stock that is going “to the moon.”
Logically, you know these are highly risky gambles. But emotionally, you start feeling a deep sense of FOMO (Fear Of Missing Out). You abandon your safe ETF and dump your savings into the same risky assets at the very top of the market. A month later, the bubble bursts, and your retirement fund is decimated.
Why did you do that? Charlie Munger calls this the “Social-Proof Tendency”. As humans, when we feel doubt or uncertainty, we naturally look at what others are doing and copy their behavior to relieve our discomfort. In the stock market, this herd mentality is fatal. Just because everyone around you is doing something stupid does not make it a smart investment. If you want to achieve FIRE, you must become comfortable with being the boring, quiet investor while others are loudly gambling.
2. The Wall Street Trap: Incentive-Caused Bias
Why do financial TV experts and stock brokers constantly tell you to buy and sell new stocks every single day?
Munger warns us about the immense power of “Incentive-Caused Bias”. This is a psychological principle stating that people will naturally justify bad or immoral behavior if they are financially rewarded for it.
When a stockbroker recommends a complex, high-fee mutual fund or pushes you to trade frequently, it is rarely because it is the best move for your FIRE portfolio. It is because their income depends on commissions and fees. Munger famously notes that he has never seen a management consultant’s report that didn’t conclude: “This problem needs more management consulting services”.
Never blindly trust someone who makes money by moving your money around. As we explored in [Part 3 of our Behavioral Economics Series: Why Wall Street Experts Can’t Beat a Coin Toss], highly paid experts routinely fail to beat simple index funds. Your greatest defense is to understand the hidden incentives of the people giving you advice.
3. The “Averaging Down” Trap: Deprival-Super Reaction Tendency
Have you ever held onto a losing stock just because you couldn’t bear the thought of making the loss real? Or worse, have you bought more of a dying asset just to lower your average purchase price?
Munger calls this the “Deprival-Super Reaction Tendency”, which is closely related to “Loss Aversion.” Human beings experience the pain of losing something much more intensely than the pleasure of gaining something equal in value.
Let me share a painful confession from my own pension account just a few weeks ago.
My original plan was simple. Following Warren Buffett’s famous advice, I intended to keep 90% of my retirement portfolio in an S&P 500 index fund and 10% in bonds. But early last year, I noticed that 30-year U.S. Treasury bonds (currency-hedged) looked incredibly cheap due to the unusually high interest rates. Assuming the Federal Reserve would soon cut rates, I bent my own rules and allocated 20% to these bonds.
But the rate cuts were delayed. As bond prices dropped, I couldn’t stand seeing that red minus sign in my account. Driven by my brain’s desperate need to erase that loss, I kept buying more to lower my average cost (averaging down). Before I knew it, I had completely stopped buying stocks, and this single bond ETF had swallowed up a massive 50% of my entire pension portfolio!
On March 25th, I finally woke up and sold every single share. On paper, my loss was about 5% (after factoring in monthly dividends). But the true damage was the opportunity cost. While my money was trapped in a losing bond, the stock market was soaring. Factoring in that missed growth, my real loss was over 15%.
I fell right into the trap. My brain wanted to erase the loss so badly that I threw good money after bad. It was a harsh reminder: never average down on a losing proposition just to soothe your ego. You must objectively evaluate the asset today, cut your losses, and reinvest that capital into a better, safer vehicle.
Conclusion: How to Outsmart Yourself
The stock market is essentially a giant machine designed to transfer money from the impatient and emotional to the rational and disciplined. Munger’s “Psychology of Human Misjudgment” teaches us that high intelligence is not enough; you must also have emotional control.
You cannot completely turn off your biological biases. But you can build systems that prevent them from ruining your wealth. Stop watching daily financial news. Stop taking stock tips from your coworkers. Automate your monthly investments so your “System 1” emotional brain never gets the chance to interfere.
Now that we understand how our minds betray us, what is the exact physical action we should take with our portfolios? Should we buy 100 different stocks to be safe? In our next post, we will explore why Munger believes massive diversification is actually madness. Stay tuned!