In part one of this article series we introduced you to Daniel Kahneman’s fast and slow thinking. Fast thinking (“system 1 thinking”) uses mental short cuts to help us react quickly, making it well suited for knee-jerk life-and-death decision-making. Slow thinking (“system 2 thinking”), uses carefully gathered evidence and a disciplined evaluation process to make decisions, making it well suited for complex, life altering decisions that don’t involve tigers.
The short cuts of fast thinking introduce bias and inaccuracy into our processes and can affect the quality of the decisions we make. In part one, we covered five biases that are probably compromising your investment decisions: availability bias, representativeness bias, affect bias, overconfidence bias and hindsight bias. This time we cover five more biases, plus signs to look out for and steps to take to slow your thinking down.
Humans have a herd mentality. In general, we’re more comfortable following others than striking out on our own and we feel good about our decisions when we see others doing the same things. It’s why people join long lines at food festivals—the more people in the line, the better the food must be, right? Not necessarily. Long food lines are more likely a comment on human psychology than culinary quality.
Financial markets are affected by the herd mentality as well. A few people jump on a new stock or invest in a country, then more join in. Eventually the trend becomes a fad, then a bubble which ultimately bursts. It happened with the Dutch tulip frenzy in the 1600s, the South Sea Island bubble of the 18th century, the U.S. stock market boom of the ‘20s and, more recently, the tech boom and real estate bubble of the early 2000s.
Signs: You have a hard time trusting your own judgement of an investment’s value, instead altering your opinion based on what others say and do. You’re influenced by the behaviour of other investors. When they sell or buy, you do too.
What to do about it: Do your research or work with a portfolio manager that will. Investigate why people are jumping on a particular investment opportunity to determine whether they’re simply following the crowd or if they have solid reasons for their decision.
Research has shown that people are more emotionally affected by losses than gains. In other words, the pleasure we experience when we gain something is less than the pain we feel when we lose, even when the value of the gain or loss is exactly the same. This leads us to work harder and take greater risks to avoid losing than to keep winning. This bias is known as “risk aversion.”
Signs: You’re reluctant to sell anything that will result in a loss. You’re more likely to sell something that’s made a gain than hold onto it. You accept higher levels of risk in order to avoid the potential of losses.
What to do about it: Look more rationally at the costs and benefits of different options, recognizing that your instinct is to avoid losses. Focus on how your portfolio is performing as a whole, rather than on what one investment may be doing at a particular point in time. By definition, portfolio diversification means that not all investments will be trending in the same direction at the same time. Keep in mind the final level of wealth you can attain, rather than viewing losses and gains relative to a subjective reference point.
Very few people like uncertainty. This leads us to be more comfortable with known risks (the devil we know) than unknown risks (the devil we don’t), to the point where we’ll choose an option known to be high risk over an option with unknown risks, even though the unknown risk could be zero. We’ll also choose an option with known odds of winning over an option with unknown odds, even though the unknown odds could be a guarantee that we’ll win. And in all cases, we rationalize our choices by saying they’re based on probability, even though they’re not really.
Signs: You steer clear of investment types, companies, countries and sectors you don’t know well. You stick with income over growth because interest rates are known and growth is uncertain. You invest primarily in Canadian investments versus looking for the best global investment opportunities. You think you’re making rational assessments of risk, but then the unexpected happens and you find yourself saying “How is that even possible?”
What to do about it: Be aware that you may want to avoid ambiguity so much that you’re using probability incorrectly. Fact check your calculations with someone who knows math well. Consider broadening your investment horizon beyond what you know, or work with a portfolio manager that specializes in investing outside Canada.
One way to speed up decision-making is to use a reference point to judge the value or merit of different options. The reference point is often the first piece of information we receive and may be otherwise irrelevant to our decision-making. It becomes an “anchor” against which we weigh all subsequent information, hence the name “anchoring bias.”
A sparkling example of anchoring is the two-months’ salary campaign by DeBeers in the 1930s. By telling men they should spend two months’ salary on an engagement ring—an arbitrary number—suddenly there was a reference point for what a ring should cost, and an expectation that a good fiancé would shell out at least that much. Outside of the diamond business, acquisition prices or highest prices paid often become anchors for investors.
Signs: You’re holding onto investments that you should sell because you’re anchoring their value to their original price rather than more important criteria.
What to do about it: Be on the lookout for anchors. When you’re using a reference point, ask yourself if it’s relevant or not. Use data instead of suppositions to make decisions.
We’re using this shortcut, called “confirmation bias,” when we look for information that confirms our pre-existing beliefs and ignore evidence that goes against those beliefs. In part, this bias exists because we find it easier to understand positively framed information.
Confirmation bias can affect investment professionals as well as individual investors. We’re vulnerable to confirmation bias when we look for strategies that work instead of strategies that don’t work, products to buy rather than ones to avoid, and evidence that what we’re doing is right not wrong.
Signs: You rarely change your mind about whether an investment is a good or poor option. You only listen to advice and accept facts that prove your point. When doing your due diligence, you phrase your questions in ways that will lead to confirming statements.
What to do about it: When doing research, spend most of your time seeking out contrary opinions and evidence. Ask questions that will challenge your pre-existing beliefs. Test and retest your investment process.
In this article we’ve covered herd bias (our tendency to follow the crowd), uncertainty aversion (our bias towards known risks), risk aversion (our focus on avoiding loss over securing gain), anchoring bias (making decisions using an arbitrary reference point), and confirmation bias (seeking evidence that confirms our beliefs).
It’s important to be aware of the signs that you’re using your fast, flawed, biased system 1 brain to make investment decisions. The next step is to invest the time and do the hard work needed for slow, disciplined system 2 thinking. Look for contrary evidence, listen to opposing opinions, rely on data, know probability, question your feelings, and understand where your biases come from. It’s the only way to feel confident that your investment decisions are, in fact, based on logic, probability and relevant evidence and not on gut feeling, stereotypes and other mental shortcuts.
This article is based on Risk, Financial Markets & You: Your Guide to Making Better Financial Decisions, a book by Adaptive ETF strategist Alan Fustey.
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