Most of decision we make in life we make without thinking. We know to turn left at the end of the road to go to work in the morning, so we do. We know that in the morning we’re tired, so we make coffee after having a shower. We know we love our partner so we give them a kiss on the cheek without consciously running through all the reasons why we should or should not love them. These mental shortcuts are absolutely necessary. Having to decide what to do in every moment would be exhausting, which is part of the reason why any big change in routine is so tiring: you come home knackered after deciding every step of your day in a new job or you exhaust yourself thinking through every interaction in a new relationship.
These mental shortcuts can act in your best interest or against it and in come cases they run deep, very deep. So deep in fact, that they’ve been present in one form or another for thousands of years. These deep seated shortcuts were crucial to our survival when we were threatened by wolves or rival tribes. They’re why we duck when we see a fast moving object, or why we focus so intently on the recent past and ignore what has come before. They’re also why so many of us lose money on the stock market.
There are some classic questions that show us some of these mental shortcuts (you may have come across these as part of dubious Facebook IQ quizzes), consider the following:
- If it takes 26 days for a lily pad which doubles in size every day to cover a pond. How long will it take for the lily pad to cover half the pond?
- If it takes one worker 10 minutes to finish 10 toys, how many minutes will it take 10 workers to finish 100 toys?
- A bag of crisps and a beer cost £4.50. The beer costs £4 more than the crisps. How much do the crisps cost?
Each of these sound easy right? See how you did, the answers are as follows:
- 25 days. If it doubles every day, then one day before it covers the pond, it must be half the size of the pond.
- It takes them 10 minutes. Multiplying the number of workers doesn’t make them work faster or slower!
- The crisps cost 25p. The beer cost £4.25, £4 more expensive than the crisps.
If you got all or some of them right, well done! You officially have an IQ of 400. If you got some or all of them wrong, don’t feel bad. Its your brain working against you. With each of these questions there’s an immediately obvious (and wrong) answer (13 days, 1 minute, 50p).
Lets look at some of the assumptions that are working against us here and how they apply to investing. If you’d like to learn more, I recommend the excellent The Little Book of Behavioral Investing by James Montier, which is a fantastic primer on this stuff.
Bias #1: We hate losing more than we love winning
I hate losing. You hate losing. People hate losing. Its entirely natural and, sadly, unavoidable. The problem is that our fear of losing can lead us to make incorrect investing decisions, particularly in market downturns.
When an average person has suffered a loss, they are much more reticent to deploy more capital. Worse, the longer they’ve been in a position where they’ve been suffering losses, the more fearful they become, and the less likely to take any risks. This is incredibly suboptimal as it leads to people selling investments when markets are at all time lows, the worst time to sell, and buying investments when markets are at all time highs, the worst time to buy!
There’s an amazing experiment showing this where the participants were tasked with betting on coin tosses, where winning would earn more than a loss. Each participant could either gamble in a round to sit it out, keeping their stake. Given the chances of winning or losing are 50/50, the best way to play is to bet on every toss. The everyday participants, people like you and me, did not do this! They only participated 58% of the time. However, a second group, who had had brain damage which had destroyed their ability to feel fear invested 85% of the time!
So how do we beat our fear in investing?
One way is to make a plan and stick to it. I mean really stick to it. Say you’re investing £500 a month. Do that in rain or shine. If markets are crashing, you invest £500 a month. If they’re doing brilliantly, again, you invest £500 a month.
Another way is a little more zen: by having courage to doing what your fear is warning you not to. Like anything, courage is a muscle. Its not the lack of fear, its the ability to rise above it, to move through it. As such, every time you push past your fear, large or small, you train yourself to have courage. This could be as small as making a joke with the waiter or as big as going skydiving.
“I must not fear. Fear is the mind-killer. Fear is the little-death that brings total obliteration. I will face my fear. I will permit it to pass over me and through me. And when it has gone past I will turn the inner eye to see its path. Where the fear has gone there will be nothing. Only I will remain.”
Frank Herbert
Bias #2: Overconfidence and Optimism
People are naturally optimistic. We wouldn’t have it any other way! A group of friends taking turns to describe how miserable they are is no ones idea of a good time. Optimism can also lead to great outcomes ranging from a longer life to success at work. Likewise, confidence, in almost all walks of life is a hugely beneficial. “Fake it til you make it” is not an empty phrase, the very act of seeming can lead to becoming over time.
However, optimism both trait can cause issues when it comes to managing your finances. Overconfidence or excessive optimism can lead a budding (or even experienced) trader to over rate their chances of success and underestimate the risks, leading to over aggressive asset allocations. This can be particularly dangerous in a bull market where every hot stock you pick rises massively. Any sane person would start to wonder why they’re bothering with bonds or index funds when they can make 80% in a year on a new biotech stock. of course, winning runs never last and the downside is even more steep than the upside. I’m no stranger to investing in individual stocks but always keep any such holdings <20% of my portfolio.
Another possible outcome of overconfidence is overtrading, racking up costs each time, as you try to chase the next big thing. Have a look at your trade history, did buying or selling out of those positions help your returns or just lead to unnecessary churn?
#3 Recency Bias
Last but not least is recency bias. My own kryptonite. We all overweight the recent past over the distant past to one extent or another. There are good reasons for this, the recent past is most similar to the present and thus the best indicator of the future. We also overweight the near future compared to the distant future. We may know that a hangover is looming if we have that shot, but dammit we’re going to have a lot of fun before we get there.
You’ve guessed it, there’s an issue with this when it comes to investing (and, to be honest, life). Having said that, you’re reading a blog about financial independence, a concept that by definition takes years and involves considerable sacrifice. That means you’re already much more interested in the long term than many other of your peers.
As much as I’d like to end up with us aggressively patting each other on the back for being so conscious of our future selves, we’re equally vulnerable to recency bias. A classic investing example of this is the market cycle.
First you have rising interest, then an idea gets widely circulated. Next, whatever asset it is starts to get expensive. Then very expensive. There are justifications, there is reasoning why it isn’t expensive really. Finally, the ultimate statement is made: “This time is different“. For a while, the believers are right. Until they’re not and it all comes crashing down.
The thing is, the whole process can take a very long time. Arguably, the current bull market has been continuing for over 10 years (given how quickly the market recovered after coronavirus). In this time US equity markets have vastly outperformed those of any other major economy. So the smart place to have your money for more than 10 years were US equities, anywhere else and you were effectively leaving money on the table.
The result of this is that US equity markets are now very expensive as people keep buying into them. Other markets (South America, the UK) are much cheaper comparatively but over the past 10 years, everyone who’s deployed their money outside of the US has lost money.
Ten years is a very long time. More than long enough for recency bias to kick in. Everyone who works in finance knows about market cycles, the general public do too though more from an economic boom and crash standpoint. Still, we get suckered in, we overweight the recent past (rising prices) and discount the distant past (followed by crashes). The same is true in corrections, we overweight the recent past (falling prices) and discount the distant past (recovery and growth).
So what can we do?
We can form an investment plan and asset allocation and, most importantly, stick to it. When each of us plans our allocation we can do so rationally, free of the emotional pull of the next hot thing. There is always room for risk in an allocation, potentially quite a lot of room depending on time horizon. If you want 5% of your assets in bitcoin, or even 10%, that’s fine but stick to the plan. Don’t deviate by selling off the more boring asset classes to go all in.
That’s it! My top three cognitive biases. I told you your brain was against you…