Dear Reader,
We are by no means perfect beings.
“I can calculate the motion of heavenly bodies but not the madness of people.” – Sir Isaac Newton
People make 35,000 decisions per day, and so by sheer volume, we are easily prone to making mistakes. From an evolutionary perspective, our very own life experiences instill preconceptions and biases in us that allow us to interpret the future with greater efficiency. If a saber-toothed tiger were found to be lurking in the tall grasses yesterday, one would tread lightly while passing through the tall grasses today.
These preconceptions and biases are subconscious and form part of what makes us all individuals. Although we cannot remove them, it is helpful to identify and to understand them, so as to limit future decision-making errors in our ever-growing path towards continuous improvement.
Behavioural economics studies the biases, tendencies and heuristics that affect the decisions we make. It aims to discover whether we make good or bad choices and whether we can be guided to make better choices.
This 3-part segment aims to explore the top 20 behavioural biases that assist (and sometimes hinder) the way we make our choices and then allows you to determine what type of investor you might be.
For reference throughout, we have used content from The Decision Lab, a socially-conscious applied research firm who provides consulting services to some of the largest organizations in the world in solving some of their thorniest problems using scientific thinking. The Decision Lab carries out research in priority areas and runs one of the largest publications in applied behavioral science. More information can be found at https://thedecisionlab.com/.
Parts 1 and 2 will explore 10 behavioural biases each and provide real-world examples to help you identify them. In part 3, we will drill down to the 8 personality types to determine who might be out there.
Can you identify any of them in yourself? I sure can.
What type of investor are you?
An overview of Behavioural Biases
Behavioural biases can be broken down into cognitive biases and emotional ones.
A cognitive bias is a systematic error in thinking that occurs when people are processing and interpreting information in the world around them and affects the decisions and judgments that they make. The human brain is powerful but subject to limitations.
An emotional bias is a distortion in cognition and decision-making due to emotional factors. That is, a person will be usually inclined to believe something that has a positive emotional effect, that gives a pleasant feeling, even if there is evidence to the contrary.
Part 1: 10 Common Behavioural Biases
1. Representativeness
When making decisions or judgments, we often use mental shortcuts or "rules of thumb". We don't have the time or resources to compare all the information before we make every choice, so we use representativeness to help us reach decisions quickly and efficiently. Most of the time, these mental shortcuts can be helpful, but in other cases, they can lead to errors.
When confronted with something new, we estimate the likelihood of an event by comparing it to an existing preconception that already exists in our minds. Our preconception is what we think is the most relevant or typical quality or outcome of a particular object or event.
Example: Sarah loves to listen to New Age music and faithfully reads her horoscope each day. In her spare time, she enjoys aromatherapy and attending a local spirituality group.”
Based on the description above, is Sarah more likely to be a schoolteacher or a holistic healer? Many people would identify her as a holistic healer based on representativeness. She fits in with our existing ideas of how a holistic healer might behave. In reality, it is far more likely that Sarah is actually a schoolteacher based purely on mathematical probability.
School teachers are far more common than holistic healers.
2. Anchoring and Adjustment
If a person is asked to estimate a value in an area they have little or no familiarity with (such as the distance to the moon) and is presented with an initial default number —an anchor—they will typically adjust this figure up or down to reflect subsequent information and analysis.
Once fine-tuned and reassessed, the anchor can sometimes mature into a final estimate. People are generally better at estimating relative comparisons than absolute figures.
Example: You are asked: “is the moon greater or lesser than 10 million meters away?” The answer given will obviously be either above or below 10 million meters.
If you were then asked to guess an absolute value for the distance to the moon, the estimate you provide will probably fall somewhere near 10 million meters, because you have been anchored by the previous response.
The moon is 384,400,000 meters from the earth.
3. Mental Accounting
Mental accounting explains how we tend to assign subjective value to our money, usually in ways that violate basic economic principles. Although money has consistent, objective value, the way we go about spending it is often subject to different rules, depending on how we earned the money, how we intend to use it, and how it makes us feel.
Example: Imagine you are walking down the street, and you happen to find a $100 bill lying on the sidewalk. Ordinarily, you are pretty frugal, and you’ve been trying to save some money to put towards buying a car in the future. Today, however, you take your newfound $100 and put it towards an expensive dinner. You tell yourself that this money isn’t “car money” — this is a one-off, this is a special occasion, this is money you didn’t expect. So why not treat yourself to a nice evening out?
4. Overconfidence
Overconfidence is defined generally as an unwarranted faith in one’s intuitive reasoning, judgments, and cognitive abilities. People tend to overestimate both their predictive abilities as well as the precision of the information they have been given. People think they are smarter and have better information than they actually do.
Example: How would you rank your communication skills as compared to the average?
When polled and in general, subjects asked to rank attributes of themselves as compared to the average rank themselves above average in almost every category. Not everyone can be above average…
5. Cognitive Dissonance
Cognitive dissonance describes when we avoid having conflicting beliefs and attitudes because it makes us feel uncomfortable. The clash is usually dealt with by rejecting, debunking, or avoiding new information.
Example: John is an avid environmentalist. He is president of the environmental club at school, goes to climate change marches, and John’s family owns an electric car.
One day, he decides to attend a lecture on the negative environmental effects of certain animal products which apparently contribute significantly to climate change. To his dismay, John realizes that he uses many of those products on a regular basis. His stomach drops:
To get rid of the pit in his stomach and resolve the identity crisis he is having, John quickly concludes that, even if animal products aren’t great for the environment, he has done so many other things that are good for the environment, that some of it must even out (at least). John’s mind is put at ease.
John rationalizes the new information so that his identity as an environmentalist isn’t painfully compromised.
6. Availability
The availability heuristic describes our tendency to use information that comes to mind quickly and easily when making decisions about the future.
Example: You are considering either John or Jane, two employees at your company, for a promotion. Each has a steady employment record, though Jane has been the highest performer in her department during her tenure.
However, in Jane’s first year, she unwittingly deleted a company project when her computer crashed. This vivid memory of having painfully lost that project likely weighs more heavily on the decision to promote Jane than it should. This is due to availability bias, which suggests that a singular memorable moment has an outsized influence on decisions.
7. Self-attribution
The self-attribution bias describes when we attribute positive events and successes to our own character or actions, but blame negative results to external factors unrelated to our character. The self-attribution bias is a common cognitive bias that has fascinated researchers globally for decades.
Example: A student gets a good grade on a test and tells herself that she studied hard or is good at the material. She gets a bad grade on another test and says the teacher doesn’t like her or the test was unfair.
Example: Athletes win a game and attribute their win to hard work and practice. When they lose the following week, they blame the loss on bad calls by the referees.
Example: A job applicant believes he’s been hired because of his achievements, qualifications, and excellent interview. For a previous position that he didn’t receive an offer for, he believes the interviewer didn’t give him a fair shot.
This process is common amongst so many of us, as our initial reaction is to praise ourselves when we achieve success and attribute it to our abilities but blame external factors for failures.
8. Illusion of Control
The illusion of control describes how we believe we have greater control over events than we actually do. Even when something is a matter of random chance, we often feel like we’re able to influence it in some way.
Example: You and your family are going to watch your favorite soccer team in the league championship match. As always, your dad wears his “lucky” jersey in the team’s colors. It’s a little small on him these days, but he insists on wearing it, because he thinks it will boost the team’s chances of winning.
9. Conservatism
Conservatism bias is a mental state in which people cling to a prior view or forecast, and do not acknowledge or obtain new information that might change an existing view. In essence, it is a tendency to insufficiently revise one's belief when presented with new evidence.
Example: An investor purchases shares in a company based on the knowledge that the company is planning a forthcoming announcement regarding a new product. The company then announces that it has experienced problems bringing the product to market. The investor may cling to the initial, optimistic impression of some imminent, positive development by the company and may fail to take action on the negative announcement.
10. Ambiguity Aversion
Ambiguity aversion describes how we tend to avoid options that we consider to be ambiguous or to be missing information. We dislike uncertainty and are therefore more inclined to select an option for which the probability of achieving a certain favorable outcome is known.
Example: While traveling through a foreign city, you look for a restaurant to dine in for the evening and have a few options to consider.
In order to better inform your decision, you decide to search online for reviews of nearby restaurants and see there are two options near your hotel. Suppose that one of the restaurants has an average rating, while the other has no ratings yet because it’s a relatively new establishment. In this scenario, most people tend to select the restaurant with the average rating; this, despite the fact that the rating isn’t great. We feel better knowing exactly what we’re getting ourselves into.
We’re scared to risk eating at a restaurant we know nothing about, on the off chance that it turns out to be terrible. However, by playing it safe, we risk missing out on a phenomenal new menu, prepared by an innovative new chef. When making decisions like these, we often forget to give equal weight to the possibility that the result of taking a risk could actually be positive.
So, did you learn anything about yourself?
In part 2 of this segment, we'll be exploring 10 more behavioural biases.
The take-home here is to ensure you have a framework for long-term investing, and to ensure your emotions, biases, and heuristics don’t cloud your judgment in sticking to that framework.
If you have any questions about your financial plan, would like our opinion on what this current financial landscape means for long-term investors, or would like a refresh on the framework we have in place for times like these, please never hesitate to reach out.
We are available and accessible to you any time through email, phone, or teleconference (video).
Be well and be safe,
Adam