Process / Philosophy · Series: Managing Investment Risk · Post 3 of 6
September 15, 2026
By Rob Nicoski, CFA · Disciplined Growth Investors · dginv.com
In our last post, we drew a critical distinction: uncertainty cannot be fully managed, but risk can. That insight is the intellectual foundation for everything that follows in our risk management framework. But knowing the distinction isn’t enough. There is another equally important obstacle standing between investors and sound risk management — one that doesn’t live in the markets or in the data. It lives inside our own heads.
There is a uniquely human attribute we need to consider if we are to develop an effective framework for assessing uncertainty and managing risk: humans are emotional creatures, not rational decision-making automatons, and emotion can skew behavior in ways that hinder optimal decision making. This is not a character flaw. It is a feature of human cognition that every serious investor must understand and account for.
On the surface, the immutable nature of uncertainty and the dynamic nature of risk seems problematic, particularly in endeavors that require a reasonably accurate forecast of the future like investing. The reality is we all have an imperfect and variable view of what the future holds. Fortunately, we possess a powerful cognitive tool to help us deal with uncertainty in any form — a sense of probabilities about future events.
It is this ability to think probabilistically that allows us humans to make sense of an array of uncertain outcomes and move toward a decision. This is why even in the face of a puzzling and sometimes opaque set of possibilities, humans tend to make most decisions with relative ease. Absent the ability to think probabilistically, we would likely freeze up at the prospect of uncertainty or default entirely to emotional impulses. As we will discuss, letting emotion drive our decision process will often push us toward suboptimal outcomes.
In practice, the probability-setting exercise generally involves assessing probabilities for the most likely as well as the most imaginably extreme outcomes. Much of this process is so embedded in repeated behavior patterns that we may no longer consciously recognize it as an exercise in probabilistic thinking. And of course, we rarely methodically assign numerical probabilities; instead, we make general assessments like “highly likely” or “unlikely.” Over time these assessments transform into cognitive shortcuts or heuristics that can be expanded to similar circumstances to promote decision-making efficiency.
Of course, our inherent capacity for assessing probabilities does not mean our probabilistic conclusions are always accurate. It only suggests that even the least mathematically inclined among us routinely engage in a rudimentary form of probabilistic thinking to deal with uncertainty over the course of our typical day.
Probabilistic thinking is the tool. But the tool can be compromised. Which brings us to the principle that may be the most underappreciated challenge facing investors at every level of sophistication.
Pioneering psychologist and behavioral economist Daniel Kahneman aptly captured this all-too-human tendency when he observed that we are “guided by the immediate emotional impact of gains and losses, not by long-term prospects for wealth and global utility.” In other words, emotional influences often override more strategic considerations in the average human’s thought processes.
In his opus, Thinking Fast and Slow, Mr. Kahneman refers to the fast-acting, reflexive part of our cognitive processes as System 1 and the deliberate, logical part as System 2. He argues that “System 1 operates automatically and quickly with little or no effort and no sense of voluntary control.” System 1 is essentially a pattern-recognition machine designed for efficiency of action. System 1 has a substantial unconscious influence on our decisions that leaves us prone to systematic cognitive errors, or biases.
These cognitive errors recur predictably under testing. For instance, whether we realize it or not, we homo sapiens are far more sensitive to the potential for loss than gain. A pioneering 1984 paper by Mr. Kahneman and Amos Tversky introduced a behavioral bias that is commonly referred to as loss aversion. Through their research, they established that when faced with an equivalent loss and gain, the average individual perceives the “pain” of the loss to be roughly twice the “benefit” of the gain.
This perceptual asymmetry between positive and negative expectations leads to overly risk-averse behavior. For instance, an exaggerated sense of risk may cause an investor to pass on intriguing investment opportunities. It also helps explain why investors commonly experience an intense urge to “cut their losses” during periods of market duress even though they may rationally comprehend that substantial market declines offer compelling long-term buying opportunities.
A second well-documented cognitive error referred to as the endowment effect causes humans to underestimate financial risk in certain situations. The endowment effect describes a perceived value change based on a difference in reference points. The reference point is ownership. Humans tend to place a higher value on an object if they own it versus if they do not own it. The endowment effect can cause an investor to overestimate the value of an existing portfolio holding and, therefore, underestimate the associated risk.
Loss aversion and the endowment effect are just two of the cognitive errors in a long list that have demonstrated the ability to unwittingly skew decision-making in unhealthy directions. They are, however, two of the more impactful cognitive biases for investors — capable of severely distorting an investor’s perception of value and risk.
Fear and greed are the two predominant emotions experienced by investors; many investment decisions are made to satisfy these emotions. Most investors have a process which can drive their decisions away from portfolio optimization. For example, average investment holding periods hover around six months. This time frame can drive decisions into the short term, away from long-term portfolio optimization. The bottom line is that reality clashes with the pivotal MPT assumption that investors routinely set aside emotion and bias to craft optimal decisions from the jumble of facts, rumors, and uncertainty common to the real world.
The impact of autonomic cognitive processes on our decision-making calls to mind a quote by Nobel prize-winning physicist Richard Feynman. Mr. Feynman once quipped: “Imagine how much harder physics would be if electrons had feelings.” Mr. Feynman was probably not directing his comments at the practice of investing specifically, but he very well could have been. Investing is an enterprise awash with emotions (especially fear and greed) and the decision-making distortions it leaves in its wake. Investors need to consider this reality to ensure it does not unwittingly undermine sound decision making.
This ability to forestall System 1 impulses — to slow down the decision-making process to allow for a sober analysis of the risks — might be Mr. Honnold’s greatest weapon for surviving and thriving in one of the world’s most dangerous occupations. His athletic conditioning and climbing expertise are surely indispensable as a lack of either would have undoubtedly led to failure on his attempt to summit El Capitan; however, many fit and talented climbers have failed at less challenging climbs, just as many intelligent and talented investors have destroyed untold amounts of wealth. The difference lies in an ability to properly harness the unique skillset he possesses with minimal emotional influences.
Yet, investors need not let their reflexive System 1 and its cognitive perturbations derail efforts to prudently assess and manage risk. Once an investor is aware of these distortions, they can protect from suboptimal decision making with process discipline. Sound process allows the investor to defend against knee-jerk decision making and purposefully engage in logic-minded System 2 thinking.
This is not a minor operational footnote. It is structural. The investor who understands that their own brain is a potential source of risk — and builds a process that accounts for it — has a meaningful edge over the investor who assumes their instincts are reliable guides.
DGI’s investment process is deliberately constructed to constrain System 1 impulses and elevate System 2 reasoning. Every element of our research process, from how we build financial models to how we size positions to how we challenge our own prior assumptions, is designed to surface the truth about a company’s risk profile rather than confirm what we hope or fear to be true.