A famous
psychologist who studied how people make economic decisions, passed away at the
age of 90. He won a Nobel Prize for his work on how our minds influence decision-making.
He wrote books like "Thinking, Fast and Slow" and
"Mistakes Bound to Happen," which have changed the way we think about
money and behavior.
There are hard-wired mental biases that can warp judgment often with counterintuitive results.
His research showed that our brains often make mistakes when it comes to money. Sometimes, we don't even realize we're doing it!
Here are some important biases from his book "Thinking, Fast and Slow" that we can learn from and be thankful for:
1) Our Brain Uses Two Systems: System 1 and System 2
• System
1 is fast, intuitive, emotional, and responsible for quick judgment & automatic
decisions. It is prone to biases and errors such as overconfidence.
• System
2 is slow, analytical, deliberate, conscious, and more rational. It is
necessary for complex tasks & reasoning, requiring focused attention.
Recognize
the signs that you are a more cognitive minefield. Be aware of when you might be
prone to making mistakes due to cognitive biases or faulty reasoning. The fast
part makes quick decisions, while the slow part thinks things through.
2) Irrationality
Humans
are not rational. We all make a lot of irrational mistakes.
• 90% of
Americans think they can drive better than average and 70% think they are
smarter than average.
• An
investor might hold onto a losing stock with the belief that it will eventually
rebound, despite evidence suggesting otherwise.
3) Prospect Theory
People
value gains and losses differently, leading to inconsistent decision-making.
• Many
people don't want to play a Heads or Tails game where they can win $100 but
risk losing $50. You should take this bet every single day.
• An
investor might panic and sell off stocks during a market downturn, fearing
further losses, even though a more rational approach would be to hold onto them
or even buy more at discounted prices.
4) Loss Aversion
Suggests
that people feel losses twice as hard as gains.
• Why does
the loss of $100 hurt about twice as much as the gain of $100 brings
pleasure? We often feel the pain of losing
money more than the joy of gaining it.
5) The Halo Effect
The halo
effect is a cognitive bias where your overall impression of a person influences
your perception of their individual traits or qualities.
• If you
like someone, you'll overestimate their capabilities and vice versa. Our first
impression of something can affect how we see it.
•
Investors might disproportionately trust the recommendations or advice of a
financial influencer simply because they have a positive impression of them,
without critically evaluating the advice itself.
6) Availability Heuristic
The
availability heuristic is a cognitive bias where you judge the likelihood of an
event based on how easily it comes to mind.
• If
something bad just happened, we might be too scared to take risks. A
good example is 9/11 which made people afraid of flying.
•
Investors might avoid investing in certain sectors or asset classes because of
recent negative news headlines, even if the long-term fundamentals suggest they
are sound investments.
7) Sunk Cost Fallacy
The sunk
cost fallacy appears when you keep investing in something even if it's not
worth it, simply because you've already invested resources in it.
• Even
if it's not worth it, we hate to admit we made a mistake. Think about
choosing to finish a boring movie because you already paid for the ticket.
• An
investor might continue to hold onto a poorly performing investment because
they've already invested a significant amount of money into it, even though
selling it would be the rational choice.
8) Confirmation Bias
People
tend to seek out information that confirms their existing beliefs and ignore
information that contradicts it.
•
Investors might only seek out news or analysis that confirms their preexisting
beliefs about a certain stock or market trend, ignoring contradictory
information that could challenge their views.
• We
ignore anything that doesn't fit our ideas. As an investor, always talk
with people who have opposing views. It will be very insightful.
9) Hindsight Bias
The
tendency, after an event has occurred, to believe that one would have predicted
or expected the outcome.
• A good
example is that after attending a baseball game, you might insist that you knew
that the winning team was going to win beforehand.
• After
a stock experiences a significant price increase, investors may claim they knew
it would happen all along, attributing their success to skill rather than luck.
10) Framing Effect
When the
way information is presented influences your decisions and perceptions, we call
it a framing effect.
•
Studies have shown that “75% lean meat” is usually preferred over “25% fat
meat”, even though it's the same thing.
• A
company announces its quarterly earnings in two ways: “The company reports that
it missed its earnings target by 10%” or “The company reports that it achieved
90% of its earnings target”. Even though both statements convey the same
information, the first framing might lead investors to perceive the company in
a more negative light, while the second framing might be perceived as more
positive, potentially affecting investors' decisions regarding buying or
selling the company's stock.
11) Anchoring Effect
The
anchoring effect is a bias where you rely too heavily on the first piece of
information you receive when making a decision.
• If you
first see a car that costs $100k and then see a second one that costs $70k, you
tend to see the second car as cheap.
• If a
person is exposed to a high price for an item first, they might be willing to
pay more for it if they were exposed to a lower price initially.
•
Investors might anchor their expectations for future returns based on past
performance, leading them to overestimate potential gains or underestimate
risks.
12) Overconfidence
The
tendency of people to be overly confident in their own abilities and judgments,
even when evidence suggests they should be more cautious. This overconfidence
can lead to poor decision-making as people may take unnecessary risks or
overlook important information.
• A
trader, overestimating their ability to predict short-term market movements,
might engage in excessive trading activity driven by unwarranted confidence,
resulting in increased transaction costs and suboptimal returns compared to a
more passive approach.
Daniel
Kahneman's work reminds us to be careful with our money and how we think about
it. We should be grateful for his insights and learn from them to make better
financial decisions.
Among
its myriad implications, it's foolish to check one’s stock portfolio
frequently, since the predominance of pain experienced in the stock market will
most likely lead to excessive and possibly self-defeating caution.
(Courtesy: TOI)
