How Thinking Costs You

That's a disastrous situation, Kahneman said: "The more closely you pay attention, the more you do things. And the more you do things, the worse off you will be." For proof, he pointed to groundbreaking research done by one of his former students, Terrance Odean, now a professor at the University of California at Berkeley. Odean has written that "overconfidence gives investors the courage of their misguided convictions."

He has gathered trading records from discount brokerage houses for hundreds of thousands of investors, and in several published studies, he has shown that when people had a choice of two stocks to sell, more often than not they sold the stock that did better in the future and held on to the one that did worse. And when they bought something new, they tended to buy a stock that did worse than the stock they just sold. As Kahneman once told Odean, "It is expensive for these people to have ideas."

It is particularly curious when investors hold on to losing stocks, as I have done with Citigroup. This is a function of something called loss aversion, a discovery that helped Kahneman win the Nobel Prize. Thaler, Kahneman's close colleague, put it this way: "Loss aversion refers to the fact that we're wired in such a way that losing money hurts more than getting money feels good." So let's say a hundred bucks falls out of my wallet, lost forever. Under loss aversion, this hurts a lot more than it feels good to find $100 that somebody else lost.

When it comes to trading, this helps explain why we would want to hold on to losers. Selling the loser, even though it gives us a tax write-off, causes us to admit we have lost. So we do something that makes us feel better: We sell the winners. This feeds our overconfidence. But as Odean's research has shown, we often sell winners that still have some winning to do. That puts stocks with upward momentum on the market for less than they are really worth long-term, allowing savvier investors to snap them up.

"What I believe is that individual investors probably as a group create the dynamics by which they lose money and institutions make money," Odean said. "They create mispricings."

Along with several co-authors , he has published a somewhat depressing study about just how much wealth can be lost by everyday investors just because they trade. Looking at data from every trade made by all investors in Taiwan from 1995 to 1999, Odean discovered that the "aggregate portfolio of individual investors suffers an annual performance penalty of 3.8 percentage points," which includes trading costs. If investors had simply bought the index and not traded at all, they would have done about 3.5 percent better. The amount of money lost was equivalent to 2.2 percent of Taiwan's gross domestic product.

So what should mere humans do about all of this?

Like most things human, it depends on which one you ask. Odean said he saw two options: Be dumb and let others make money off you, or just buy a no-load index mutual fund and stop focusing on beating the market. Kahneman said there was no one-size-fits-all advice, but he liked the idea of having one sure thing and one long shot. The personal finance planners say investors should stick with them -- they get paid to understand this stuff, and to win. Of course, they are humans too, which means they could be prone to the same problematic behaviors.

As for me, I'm taking some responsibility for myself, which is probably where everyone should start. Earlier this week, I logged in to my Schwab account. I sold my Citigroup shares, at a loss. I'm going to push the money into an index fund. The move felt bad, no doubt about it. I didn't fix what was in my head, but I did fix what my head had done.