In a previous blog, The Psychology of Investing, we discussed how the concepts of loss aversion, recency bias, and selective memory can impact an investment strategy and tolerance for risk. None of us are immune to these potential psychological traps, so it’s important to be aware of the underlying feelings motivating our investment decisions. It’s a challenging but necessary exercise to separate our rational, analytical mind from our emotional response to the highs and lows of market fluctuations (and any other life circumstances we may be navigating at the time). In many ways, investing isn’t only about how the market behaves, but how we react to watching our wealth rise and fall as well. With this in mind, let’s further examine how our conscious and unconscious perceptions are intertwined with the choices we make for our investment portfolios.
The studies and theories of Israeli psychologists Daniel Kahneman and Amos Tversky provide much of the basis for how we have come to understand behavioral economics. Their work centered around human judgement and decision-making; judgement is guessing the probability and significance of an outcome whereas decision-making is how we choose an option when the result is unpredictable. Prior to their work, modern economic theory held that people were generally deliberate and levelheaded with the choices they make, allowing them to correctly guess the likelihood of different results or, at least, not estimate them in a biased way. However, we now understand that human error is normal and to be expected, perhaps especially when it comes to money.
In his book, Thinking, Fast and Slow, Kahneman presents human thought as two distinct but interdependent systems. System 1 is an automatic, gut-reaction; it’s emotional, intuitive, and habitual. System 2 is slower and requires conscious effort; it’s logical, calculated, and hesitant. For example, system 1 is in control when you do things with little thought, like jump out of the way of an oncoming car or button your shirt. System 2 usually has the reigns when you do things that demand focus like search for a parking spot in a crowded lot or solve a math problem in your head. System 1 is making your decisions the majority of the time with system 2 stepping in for support when needed. What happens inside your mind can be somewhat of a wrestling match; oftentimes system 1 is unreasonably confident that it instantly knows the answer and system 2 is called into action to work through the details that system 1 couldn’t, or didn’t want to, handle. When we apply this to financial decisions, it’s clear how easily our brains can make irrational choices for us before we have a chance to realize the error we’ve made.
- The Law of Small Numbers
The law of small numbers is a cognitive bias referring to how people tend to impulsively make sweeping assumptions based on little evidence. For instance, say your new financial advisor has had above-average performance results for the last couple years, so you determine that she must be better than the average advisor. But short term high-performance can be due to various factors and is not indicative of future returns. In fact there could be information beyond performance results that could lead to you working with a different financial professional that, ultimately, provides a more rewarding relationship.
The same can be applied to specific investment vehicles, like a stock or a bond, when one assumes that a position must be better than another based on the gain or interest payout over a short period of time. Looking at small samples of information can cause you to incorrectly prefer one position over another, when perhaps what appears to be the lame duck is actually the better long term investment, but you didn’t pause to consider all of the data available. System 1 is deciding too quickly before system 2 has a chance to interject, slow you down, and encourage further investigation before proceeding. If you’re about to make a hasty or emotional decision about your portfolio, pause and scrutinize the information you’re working with, is it enough to go on or should you hold off and do more research first?
- How Framing Influences Our Decisions
Framing is another bias that causes decision makers to react differently to various scenarios depending on how the context of a choice is presented. This can be particularly problematic for investors because it can cause us to view investment options as good or bad based on how they appear or sound in the moment rather than the actual data. The possibility of being influenced by a framing bias rises when investors don’t have access to or an understanding of all the information, causing them to react automatically, using system 1, before system 2 can stop the emotional response.
To view this in action, consider the words companies use to report their earnings to shareholders. If the company had a surprisingly strong quarter, it may emphasize the positivity of the situation, but if the reports are not in the company’s favor, it may frame its statements to downplay the negativity of the information. For example, “In Q3, our Earnings Per Share soared to $1.75, compared to expectations of only $1.57.” versus “In Q3, our Earnings Per Share were $1.17, compared to Q2 when they were $1.15.” The addition of words that highlight the increase in the first statement, and the omission of expectations and words that would direct your attention to the lower increase in the second statement are ways that framing can affect our perception of how well our portfolios are performing.
We’re all susceptible to the variety of cognitive biases potentially affecting our decision making. The greatest chance of success is achieved not by making impulsive decisions, but by taking a full accounting of all the information available. Emotions can saunter their way into our thinking in so many ways: excitement for an opportunity, worries about the future, greed from a previous win, or even fear of missing out. As you consider making changes to your investments, take the time you need to come to a neutral and analytical decision. Regardless of whether or not you’re making decisions about your overall risk level, allocation of investment vehicles, specific positions, or anything in between, it’s always a wise idea to consult a professional like a CERTIFIED FINANCIAL PLANNER™ before proceeding. Sometimes two minds are better than one, especially if your mind’s systems 1 and 2 are in a standoff!