n a world where everything moves at breakneck speed, our brains are responding by prioritising and filtering out the information that surrounds us. While this may come in handy in our day-to-day tasks, the same mechanism may lead to serious problems when making complex decisions such as investing, which can have a long-lasting impact on our financial wellbeing. Therefore, if you’re here to learn about the tricks your mind plays on you and how you can address them, I encourage you to read on!
When making decisions, policymakers use simplifying assumptions to model the way our world works. Broadly speaking, economics is defined as the study of allocating scarce resources. Economic agents (i.e. people) are thought to be rational decision-makers who hold perfect information about what happens in the market and how that influences the choices they face daily. Economic theory also tells us that people can make decisions that maximise their level of satisfaction (or utility). The persona I have just described is widely referred to as Homo Economicus. In layman’s terms, everyone faces constraints imposed by 24-hour days and monthly income, among others. When faced with decisions such as making stock investments, or choosing the next movie to watch on Netflix, Homo Economicus can both make sound investment decisions because they know and understand market information, as well as accurately choose what movie will entertain them most this evening.
- Mental shortcuts and cognitive biases
Heuristics, or mental shortcuts, are strategies subconsciously used by people to answer questions, make decisions or derive solutions to everyday problems. Our brains save us time when tackling these actions by resorting to the experience and information we have gathered to date (or intuition). If any given mental shortcut works well over time, it becomes an algorithm. To put it into perspective, (publicity spot starting in 3…2…1) next time you wish to gain valuable opinions on various market trends and events, you could avoid the information overload from Google and drop by the Pynk Community by default if you’re satisfied with what you are learning. Nevertheless, while heuristics can help us make sense of the world and reduce our mental load, they aren’t always perfect. There are cases when mental shortcuts are used inappropriately, which leads to systematic errors of judgment (i.e. cognitive bias). For example, if you are new to investing and believe that trading will make you rich overnight after watching a hyped 10 years old Youtuber making investment recommendations, think twice, you are heavily mistaken.
Now that you have an overarching idea of what a mental shortcut is and how that can turn into cognitive bias, let us dismantle some fundamental assumptions that lie at the heart of economics. As the illustration above suggests, applying mental shortcuts to everyday decisions is fast and effortless, but results could prove that this approach is prone to errors. For example, neither one of us holds perfect market information as to what the next best-performing companies will be; that’s especially true when faced with a pool of roughly 5,500 publicly listed companies to choose from in the US alone. To put it into perspective, glancing over the list of the top 20 best performing US stocks of the last decade (as presented by MarketWatch) would leave most people wondering what some of these companies do.
The same problem also applies to more trivial decisions. Let’s be honest, even with decent market information, finding a movie you love is difficult. For reference, a total of 786 movies were released in 2019 in the US alone and trailers do little in the way of helping you choose a movie. Oftentimes, trailers are just the equivalent of Youtube click baits.
While the tasks mentioned above exhibit different incentives and levels of difficulty, one thing is sure, making decisions that always maximise either monetary gains or satisfaction is something far-fetched from reality. Hence, we are safe to assert that Homo Economicus belongs to the mythical creatures of the 21st century. Now that we have dismissed the assumption that economic agents are permanently self-aware and rational, we can discuss some of the cognitive traps associated with making decisions.
- The Sunk Cost Fallacy
If I were to rank my favourite cognitive biases, the sunk cost fallacy would be among my top 3 alongside the Dunning-Kruger effect and the hot-hand fallacy. Why? I believe they reflect the most damaging tendencies of subconscious human behavior. Learning how to identify and control them goes a long way in making our lives easier.
The sunk cost fallacy is described as a tendency to follow through on an endeavour if we have already invested money, effort, or time into it, regardless of the associated costs and benefits of pursuing it. Factoring in sunk costs into our current decision-making is irrational because irrecoverable costs cannot be used as a rationale for pursuing certain decisions. Only future costs and benefits should be taken into account.
Let’s assume that you bought into the hype of trading bankrupt Hertz, drawn by the delusion of getting rich quick. Thirty minutes after you placed a trade, you realise that your position has been liquidated and 50% of the money you allocated is now lost. Driven by emotion, the sunk cost fallacy may kick in, driving you to place an additional trade to recover what you have lost. More often than not, this leads to further loss, leaving you worse off. Were you to acknowledge that you are under the spell of cost sunk fallacy and control your emotions, you wouldn’t have suffered the additional loss. Remember, don’t factor irrecoverable costs into your decision making. Ask yourself, what are the current/future costs of pursuing this further? Do benefits outweigh the costs? As Pouneh highlighted in her blog post, A Key To Better Returns…… Review Your Portfolio With Fresh Eyes, your investments ought to undergo preliminary and periodic risk/reward scenario analyses to qualify as sound investment decisions.
- Dunning-Kruger Effect
As I highlighted in a recent thread, the Dunning-Kruger effect tells us that people overestimate their ability and knowledge when they have some but little expertise in a given area.
Let’s assume that you are new to investing and decide to watch a few youtube videos to come to grips with the basics. After watching a few videos you feel like you have made considerable improvements, moving from zero knowledge to some level of understanding as to how investing works. At this point, while your level of knowledge may be minimal, the jump you have made from zero knowledge to some knowledge gives you an erroneous perception of expertise, which sets you up for serious trouble (Mt. Stupid), especially if money is involved. You have decided to put your newly acquired skills to test and eventually find out, the tough way, how little you know (Valley of Despair). Reflecting on the wrong turn you took, you get over the hype of investing and realise this is something for the long term. Convinced you want to stay on top of your financial life and avoid rash decisions, you will gradually make your way up the slope of enlightenment towards the plateau of sustainability.
To wrap up, acknowledging when mental shortcuts kick in takes time. While we shouldn’t rule them out from our everyday lives, we should pay attention to situations where mental shortcuts assault our decision-making system, particularly at times when complex situations with a long-term effect are at stake.
Disclaimer: Please bear in mind that this information does not constitute any form of advice or recommendation by Pynk One Ltd. and is not intended to be relied upon by users in making (or refraining from making) any investment decisions. Appropriate independent advice should be obtained before making any such decision. When investing, your capital is at risk and you may recover less than the initial investment.