Finally! After pouring my heart and soul into this project for more than 2 months it’s here! This post contains the main introduction to my eGuide (the Practical Guide To Curing Investment Bias) which is available for FREE via subscription to ContrarianVille. Sign up and a free copy will immediately be sent to your inbox. If you have already subscribed to ContrarianVille and would like a copy please re-subscribe to the new email list (you can unsubscribe to the old one) or simply send me an email at email@example.com or contact me via twitter @ContrarianVille.
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Instead of being sensible and identifying ourselves with our brains, we identify ourselves with a very small operation of the brain – which is the faculty of conscious attention.
To better demonstrate just how minor a role conscious processing plays relative to the processing that goes on inside the human brain as a whole, consider this fact: according to physiologists, the brain receives, processes, and filters some 11 million bits of information from the senses each and every second – but the conscious mind is able to process only about 40 bits per second. This means that the “data” that we are consciously aware of is only about 0.00036% of the amount of information processing that goes on inside the brain.
Daniel Kahneman likens our perception of our own conscious awareness to a supporting character in a movie who thinks that she’s the hero. Croskerry et al. point out that cognitive psychologists estimate that the average person makes roughly 95% of their day-to-day decisions based on unconscious intuitions rather than deliberate, conscious problem solving.
The vast majority of people are completely unaware of how much of our lives are dictated by unconscious processing.
Since the Enlightenment we have viewed people as being highly rational, with some small exceptions. Due to advances in evolutionary biology, cognitive neuroscience, and history we now know that this view is patently false. People continually make substantial deviations from rationality that are systematic in nature.
That old quote (I don’t quite remember who it’s by) is very apt here:
Humans are not the descendants of fallen angels, but of risen apes.
Contrary to what Descartes thought, “we” (referring to conscious awareness) are not a “disembodied intellect” whatsoever. We are not separate from our brains, and our brains are not separate from our bodies. Our bodies are not separate from nature, and there is no evidence to suggest that humans are the only part of the Animal Kingdom which are born without an array of hard-wired instincts (i.e., we are not born with a “blank slate” – Steven Pinker has a great book on this), or that we do not develop conditioned, instinctual responses over our lifetimes.
Because so much of our thought process is hidden from us, and is based on vast connections of associated memory networks, and is driven by a process of seeking out connections rather than by a process of logic, systematic errors in reasoning occur whenever the unconscious mind plays a role in decision making (which is, to at least some degree, taking place at all times).
According to Croskerry et al. the first stages of “cognitive debiasing” involve moving from a state of ignorance regarding not only the existence of the various cognitive biases, but also of the extent to which they influence our daily decisions, to a state of awareness.
It is therefore my goal in this introductory post to cover these first stages and convince the readers that human beings are not only imperfectly rational in some small anomalous ways – but that we make large, persistent, and systematic deviations from rationality on a continual basis.
The methods and techniques for overcoming many forms of cognitive bias will then be detailed in the Practical Guide To Curing Investment Bias.
According to Daniel Kahneman, people:
-overweight the present over the future;
-overweight losses over gains;
-overweight the amount over the probability (for lottery tickets);
-overweight information that is currently available over information we do not have;
-overweight emotional factors over dry factors;
-overweight vivid examples over statistical information;
-underweight base rate figures because there is a tendency to think about and focus on individual cases
And Charlie Munger adds that there is an enormous tendency for people to under-recognize the power that incentives play in decision making.
Many of the cognitive biases that plague decision makers would likely have been highly adaptive – or useful, in the ancestral environment in which we evolved.
For example, animals that are (relatively speaking) far more fearful of losses than they are of gains would be more likely to avoid taking big risks with their lives and likely would have survived to pass on their genes at greater rates. This explains how the well-documented phenomenon known as loss aversion could have evolved in our early ancestors – and studies show that loss aversion plays an enormous role in economic decision making. The average loss aversion ratio ranges between about 1.5X to 2.5X (meaning that most people are roughly twice as fearful of losses relative to equivalent gains). In order to risk $100 on a coin flip, most people would require roughly a $200 pay-off to take the risk (“Heads I win $200, tales I lose $100″) – contrary to rational decision making odds which dictate that people ought to be willing to take any bet with a positive expected value (at 50-50 odds that would imply any reward in excess of $100 for a $100 risk).
What loss aversion means is that there is a kink in people’s value function at the origin, which represents an arbitrary reference point distinguishing losses from gains. Anything below the arbitrary reference point is a loss and anything above it is a gain. Almost everybody knows this intuitively, here’s a Kahneman and Tversky example:
If today Jack and Jill each have a wealth of $5 million, but yesterday Jack only had $1 million whereas Jill had $9 million, would they be equally as happy (i.e., have the same utility)?
Clearly Jack will be thrilled that his net worth quintupled overnight from $1 million (Jack’s reference point) to $5 million, and clearly Jill will be crushed and mortified as she has lost almost half her wealth (reference point of $9 million). This phenomenon shouldn’t exist according to standard economics – all that ought to matter are end states (such as the ending state of utility).
See that’s just the problem. The word “ought”. Economists largely consider the way people ought to behave, but they ought to consider the way people actually behave as well.
Charlie Munger put it best:
How could economics not be behavioral? If it isn’t behavioral, what the hell is it? And I think it’s fairly clear that all reality has to respect all other reality. If you come to inconsistencies, they have to be resolved, and so if there’s anything valid in psychology, economics has to recognize it, and vice versa.
Daniel Kahneman was shocked when he found out that the worldview of the economists just down the hall from him was that people are highly rational, self-interested, and that their tastes do not change – all known to be demonstrably false assumptions in the psychological literature for quite some time. Richard Thaler coined the term “Econs” to poke fun at the seemingly different organism that inhabited the realm of economic theory compared with how humans actually behave in the real world.
Almost all of the following examples are directly from Kahneman and Tversky.
For instance, Econs should be indifferent to alternative ways of describing the same thing (termed “equivalent frames”) but humans are not. Kahneman and Tversky showed that humans view cold cut meat which is labeled as 20% fat free far more favourably than they view the same piece of cold cut labeled as 80% fat (which is conveying exactly the same information, just from a different perspective – or frame).
Econs are supposed to view the future as a multitude of possible events occurring with a given probability associated with each event, but Kahneman, Shiller, and other researchers show that the human mind is wired to roughly reduce the probability of an event taking place in the future into one of three categories: won’t happen, might happen, or will happen.
Econs are guided by the long-term prospects of wealth and maximizing utility, but humans are guided by the immediate emotional impact of gains and losses. -Kahneman
Modern Portfolio Theory, which is based on the standard economic view – and therefore the view that people behave as Econs, accepts that there are emotional investors – but asserts that rational investors swiftly arbitrage away any price distortions, and thus rational investors dominate stock market prices. But Thomas Howard asks us to consider the ramifications if this picture were backwards. What if emotional and heavily biased investors actually predominantly influence stock market fluctuations? How would that change our understanding of markets and portfolio management?
As Nobel prize laureate Robert Shiller’s research concluded:
After all the efforts to defend the efficient markets theory there is still every reason to think that, while markets are not totally crazy, they contain quite substantial noise, so substantial that it dominates the movements in the aggregate market. The efficient markets model, for the aggregate stock market, has still never been supported by any study effectively linking stock market fluctuations with subsequent fundamentals.
So I hope I’ve convinced you that humans operate under very imperfect conditions of rationality, and I hope that you’re motivated enough to move on to tackling the Practical Guide To Curing Investment Bias, which goes into great depth exploring a wide variety of specific cognitive biases that impact investment decision making and suggests tailor-made methods for overcoming them.
Don’t be, as Munger says, a one-legged man (or woman) in an ass kicking contest. Subscribe and get a FREE copy of the Practical Guide To Curing Investment Bias today and arm yourself against your emotions and protect your investment returns from cognitive errors.
All citations for information and quotes in this article can be found in the eGuide.