More Praise for The Warren Buffett Way, First Edition

Part of the reason myopia provokes such an irrational response is an-
other bit of psychology: our innate desire to avoid loss.
Loss Aversion
According to behaviorists, the pain of a loss is far greater than the enjoy-
ment of a gain. Many experiments, by Thaler and others, have demon-
strated that people need twice as much positive to overcome a negative.
On a 50/50 bet, with precisely even odds, most people will not risk any-
thing unless the potential gain is twice as high as the potential loss.
This is known as 
asymmetrical loss aversion:
The downside has
a greater impact than the upside, and it is a fundamental aspect of
human psychology. Applied to the stock market, it means that investors
feel twice as bad about losing money as they feel good about picking
a winner.
This aversion to loss makes investors unduly conservative, at great
cost. We all want to believe we made good decisions, so we hold onto
bad choices far too long in the vague hope that things will turn around.
By not selling our losers, we never have to confront our failures. But if
you don’t sell a mistake, you are potentially giving up a gain that you
could earn by reinvesting smartly.
Mental Accounting
A f inal aspect of behavioral f inance that deserves our attention is what
psychologists have come to call 
mental accounting.
It refers to our habit
of shifting our perspective on money as surrounding circumstances

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T H E W A R R E N B U F F E T T W AY
change. We tend to mentally put money into different “accounts,” and
that determines how we think about using it.
A simple situation will illustrate. Let us imagine that you have just
returned home from an evening out with your spouse. You reach for
your wallet to pay the babysitter, but discover that the $20 bill you
thought was there, is not. So, when you drive the sitter home, you stop
by an ATM and get another $20. Then the next day, you discover the
original $20 bill in your jacket pocket.
If you’re like most people, you react with something like glee. The
$20 in the jacket is “found” money. Even though the first $20 and the
second $20 both came from your checking account, and both represent
money you worked hard for, the $20 bill you hold in your hand is money
you didn’t expect to have, and you feel free to spend it frivolously.
Once again, Richard Thaler provides an interesting academic ex-
periment to demonstrate this concept. In his study, he started with two
groups of people. People in the f irst group were given $30 in cash and
told they had two choices: (1) They could pocket the money and walk
away, or (2) they could gamble on a coin f lip. If they won they would
get $9 extra and if they lost they would have $9 deducted. Most (70
percent) took the gamble because they f igured at the very least they
would end up with $21 of found money. Those in the second group
were offered a different choice: (1) They could gamble on a coin toss—
if they won, they would get $39 and if they lost they would get $21; or
(2) they could get an even $30 with no coin toss. More than half (57
percent) decided to take the sure money. Both groups of people stood
to win the exact same amount of money with the exact same odds, but
they perceived the situation differently.
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Risk Tolerance
In the same way that a strong magnet pulls together all the nearby
pieces of metal, your level of risk tolerance pulls together all the ele-
ments of the psychology of f inance. The psychological concepts are ab-
stract; where they get real is in the day-to-day decisions that you make
about buying and selling. And the common thread in all those decisions
is how you feel about risk.
In the last dozen or so years, investment professionals have devoted
considerable energy to helping people assess their risk tolerance. At first,

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it seemed like a simple task. By using interviews and questionnaires, they
could construct a risk profile for each investor. The trouble is, people’s
tolerance for risk is founded in emotion, and that means it changes with
changing circumstances. When the market declines drastically, even
those with an aggressive profile will become very cautious. In a booming
market, supposedly conservative investors add more stocks just as quickly
as aggressive investors do.
A true picture of risk tolerance requires digging below the surface
of the standard assessment questions and investigating issues driven by
psychology. A few years ago, in collaboration with Dr. Justin Green of
Villanova University, I developed a risk analysis tool that focuses on
personality as much as on the more obvious and direct risk factors.
Summarizing our research, we found that propensity for risk taking
is connected to two demographic factors: gender and age. Women are
typically more cautious than men, and older people are less willing to
assume risk than younger people. Looking at personality factors, we
learned that the investor with a high degree of risk tolerance will be
someone who sets goals and believes he or she has control of the envi-
ronment and can affect its outcome. This person sees the stock market
as a contingency dilemma in which information combined with ra-
tional choices will produce winning results.
For investors, the implications of behavioral f inance are clear: How
we decide to invest, and how we choose to manage those investments,
has a great deal to do with how we think about money. Mental ac-
counting has been suggested as a further reason people don’t sell stocks
that are doing badly: In their minds, the loss doesn’t become real until
they act on it. Another powerful connection has to do with risk. We are
far more likely to take risks with found money. On a broader scale,
mental accounting emphasizes one weakness of the eff icient market hy-
pothesis: It demonstrates that market values are determined not solely
by the aggregated information but also by how human beings process
that information.
T H E P S Y C H O L O G Y O F F O C U S I N V E S T I N G
Everything we have learned about psychology and investing comes
together in the person of Warren Buffett. He puts his faith in his

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own research, rather than in luck. His actions derive from carefully
thought-out goals, and he is not swept off course by short-term events.
He understands the true elements of risk and accepts the consequences
with conf idence.
Long before behavioral f inance had a name, it was understood and
accepted by a few renegades like Warren Buffett and Charlie Munger.
Charlie points out that when he and Buffett left graduate school, they
“entered the business world to f ind huge, predictable patterns of ex-
treme irrationality.”
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He is not talking about predicting the timing,
but rather the idea that when irrationality does occur it leads to pre-
dictable patterns of subsequent behavior.
When it comes to investing, emotions are very real, in the sense
that they affect people’s behavior and thus ultimately affect market
prices. You have already sensed, I am sure, two reasons understanding
the human dynamic is so valuable in your own investing:
1. You will have guidelines to help you avoid the most common
mistakes.
2. You will be able to recognize other people’s mistakes in time to
prof it from them.
All of us are vulnerable to individual errors of judgment that can
affect our personal success. When a thousand or a million people make
errors of judgment, the collective impact is to push the market in a
destructive direction. Then, so strong is the temptation to follow the
crowd, accumulated bad judgment only compounds itself. In a turbu-
lent sea of irrational behavior, the few who act rationally may well be
the only survivors.
Successful focus investors need a certain kind of temperament. The
road is always bumpy, and knowing the right path to take is often coun-
terintuitive. The stock market’s constant gyrations can be unsettling to
investors and make them act in irrational ways. You need to be on the
lookout for these emotions and be prepared to act sensibly even when
your instincts may strongly call for the opposite behavior. But as we have
learned, the future rewards focus investing significantly enough to war-
rant our strong effort.

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The Unreasonable Man
G
eorge Bernard Shaw wrote, “The reasonable man adapts himself
to the world. The unreasonable one persists in trying to adapt the
world to himself. Therefore all progress depends on the unrea-
sonable man.”
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Shall we conclude that Buffett is “the unreasonable man”? To do so,
we must presume that his investment approach represents progress in the
financial world, an assumption I freely make. For when we look at the
recent achievements of the “reasonable” men, we see at best unevenness,
at worst disaster.
The 1980s are likely to be remembered as the