The fallacies of heuristics and other mindsets
I recently attended a lunchtime presentation on behavioral finance, and yes whilst the sashimi was deliciously fresh, the ideas were even more appetizing. The session ran through a number of common investor mindsets, such as the recency effect, confirmation bias and disposition effect (I'll go through them briefly later), but the one that struck me the most was heuristics, or simply put "mental shortcuts".
To illustrate, in the room below there are two red lines, which one is longer?
If you answered the one on top, unfortunately you're wrong, they are actually both the same length! Congrats to the smart cookies out there who got it right.
Heuristics are all about making quick assumptions or judgments, based on our historical experiences.
In some instances they are essential, i.e. when you see a tiger, you don't stop and think, you just run. But in other instances, taking mental shortcuts may not always be correct. You see a chic at the club with an exceptionally skimpy outfit and immediately go "she must be a slut", but what if she was actually a really conservative girl, and was coaxed/pressured by her friends to dress a certain way for a particular occasion? In the investing landscape, this can obviously apply as well.
The opposite to heuristics is deep thinking. This is a process that takes a great amount of mental effort and energy, and because of this, people often end up taking mental shortcuts instead. Whilst deeper thinking takes more effort and needs to be "switched on", heuristics is "always on". Back to the club example, who is going to bother to think a bit more about whether the chic is really a slut or whether there are other reasons for her dressing in a certain way (especially after a few drinks). It takes too much effort doesn't it? So let's just label her a slut. And 90% of the time that might be right, but there's that 10% that it's wrong. And in the investing world, where you are managing hundreds of thousands, millions or even billions of dollars, you can't afford to be wrong 10% of the time (at least not at a portfolio level without measures to hedge your bets). Of course people don't set out to take shortcuts, their goal is to make measured and well considered investment decisions, but often the need to make a quick decision under stressed conditions, peer pressure and other factors may come into play.
But even outside of the investing world, too often people take mental shortcuts and make the wrong (but possibly easiest) decision. In small unimportant matters who cares, but for other bigger things, the danger is that one does not even realise that they are taking mental shortcuts, and just judging on limited information because its easier, and more comfortable.
Now back to some of the other behaviour tendencies. You may have heard of these before, but its always useful to be reminded of them, so you can catch yourself from employing them:
Recency effect - this is where people tend to let things that happened most recently influence their decisions, and forget things that happened in the past. For example, if you just got a speeding fine or parking ticket you might be a bit more careful for the first few weeks, but after a while you tend to forget about it and continue on with your reckless driving. Perhaps the record low VIX (market stress indicator) levels can be partly explained by this, as markets have experienced years of solid equity market returns, they tend to forget the corrections that occur.
Confirmation bias - this is where you look for evidence to confirm your theory, and ignore facts that disapprove it. For example, you start looking for a house, and suddenly you notice that there are a lot more "for sale" signs around. Is this because there are suddenly more houses for sale? Unlikely not, its just that your brain is suddenly noticing the same amount of "for sale" houses.
Disposition effect - this refers to the tendency of investors to sell shares that have gone up too early, and to hold on to shares that have gone down for too long. Why? Because selling a share that has gone down is like admitting "you were wrong", its admitting defeat. Whereas selling a share that has gone up and crystalising that gain is locking in your profits. It's confirmation that "you were right", because you made money on that stock.
That's it folks, a short piece to prompt you to think. Perhaps it will help with your upcoming Xmas shopping, and hopefully prevent you from making rash decisions!
To illustrate, in the room below there are two red lines, which one is longer?
If you answered the one on top, unfortunately you're wrong, they are actually both the same length! Congrats to the smart cookies out there who got it right.
Heuristics are all about making quick assumptions or judgments, based on our historical experiences.
In some instances they are essential, i.e. when you see a tiger, you don't stop and think, you just run. But in other instances, taking mental shortcuts may not always be correct. You see a chic at the club with an exceptionally skimpy outfit and immediately go "she must be a slut", but what if she was actually a really conservative girl, and was coaxed/pressured by her friends to dress a certain way for a particular occasion? In the investing landscape, this can obviously apply as well.
The opposite to heuristics is deep thinking. This is a process that takes a great amount of mental effort and energy, and because of this, people often end up taking mental shortcuts instead. Whilst deeper thinking takes more effort and needs to be "switched on", heuristics is "always on". Back to the club example, who is going to bother to think a bit more about whether the chic is really a slut or whether there are other reasons for her dressing in a certain way (especially after a few drinks). It takes too much effort doesn't it? So let's just label her a slut. And 90% of the time that might be right, but there's that 10% that it's wrong. And in the investing world, where you are managing hundreds of thousands, millions or even billions of dollars, you can't afford to be wrong 10% of the time (at least not at a portfolio level without measures to hedge your bets). Of course people don't set out to take shortcuts, their goal is to make measured and well considered investment decisions, but often the need to make a quick decision under stressed conditions, peer pressure and other factors may come into play.
But even outside of the investing world, too often people take mental shortcuts and make the wrong (but possibly easiest) decision. In small unimportant matters who cares, but for other bigger things, the danger is that one does not even realise that they are taking mental shortcuts, and just judging on limited information because its easier, and more comfortable.
Now back to some of the other behaviour tendencies. You may have heard of these before, but its always useful to be reminded of them, so you can catch yourself from employing them:
Recency effect - this is where people tend to let things that happened most recently influence their decisions, and forget things that happened in the past. For example, if you just got a speeding fine or parking ticket you might be a bit more careful for the first few weeks, but after a while you tend to forget about it and continue on with your reckless driving. Perhaps the record low VIX (market stress indicator) levels can be partly explained by this, as markets have experienced years of solid equity market returns, they tend to forget the corrections that occur.
Confirmation bias - this is where you look for evidence to confirm your theory, and ignore facts that disapprove it. For example, you start looking for a house, and suddenly you notice that there are a lot more "for sale" signs around. Is this because there are suddenly more houses for sale? Unlikely not, its just that your brain is suddenly noticing the same amount of "for sale" houses.
Disposition effect - this refers to the tendency of investors to sell shares that have gone up too early, and to hold on to shares that have gone down for too long. Why? Because selling a share that has gone down is like admitting "you were wrong", its admitting defeat. Whereas selling a share that has gone up and crystalising that gain is locking in your profits. It's confirmation that "you were right", because you made money on that stock.
That's it folks, a short piece to prompt you to think. Perhaps it will help with your upcoming Xmas shopping, and hopefully prevent you from making rash decisions!
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