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Dear Adam,
We are by no means perfect beings.
“I’d rather regret the things I’ve done than regret the things I haven’t done.” - Lucille Ball
People make 35,000 decisions per day, and so by sheer volume, we are easily prone to making mistakes. From an evolutionary perspective, our very own life experiences instill preconceptions and biases in us that allow us to interpret the future with greater efficiency. For example, if a saber-toothed tiger were found to be lurking in the tall grasses yesterday, one would tread lightly while passing through the tall grasses today.
These preconceptions and biases are subconscious and form part of what makes us all individuals. Although we cannot remove them, it is helpful to identify and to understand them, so as to limit future decision-making errors in our ever-growing path towards continuous improvement.
Behavioural economics studies the biases, tendencies, and heuristics that affect the decisions we make. It aims to discover whether we make good or bad choices and whether we can be guided to make better choices.
This 3-part segment aims to explore the top 20 behavioural biases that assist (and sometimes hinder) the way we make our choices and then allows you to determine what type of investor you might be.
For reference throughout, we have used content from The Decision Lab, a socially-conscious applied research firm that provides consulting services to some of the largest organizations in the world in solving some of their thorniest problems using scientific thinking. The Decision Lab carries out research in priority areas and runs one of the largest publications in applied behavioral science. More information can be found at https://thedecisionlab.com/.
Parts 1 and 2 will explore 10 behavioural biases each and provide real-world examples to help you identify them. In part 3, we will drill down to the 8 personality types to determine who might be out there.
You can find Part 1 and past publications at https://www.adamschacter.com/blog-1
Can you identify any of these in yourself? I sure can.
What type of investor are you?
An overview of Behavioural Biases
Behavioural biases can be broken down into cognitive biases and emotional ones.
A cognitive bias is a systematic error in thinking that occurs when people are processing and interpreting information in the world around them and affects the decisions and judgments that they make. The human brain is powerful but subject to limitations.
An emotional bias is a distortion in cognition and decision-making due to emotional factors. That is, a person will be usually inclined to believe something that has a positive emotional effect, that gives a pleasant feeling, even if there is evidence to the contrary.
Part 2 – 10 More Behavioural Biases
1. Loss Aversion
Loss aversion is a cognitive bias that describes why, for individuals, the pain of losing is psychologically twice as powerful as the pleasure of gaining. Most people are willing to take much more risk to avoid a loss than they will to earn a gain, even when the economic results are the same. The loss felt from money, or any other valuable object, can feel worse than gaining that same thing. Loss aversion refers to an individual’s tendency to prefer avoiding losses versus acquiring equivalent gains. Simply put, it’s better not to lose $20, than to find $20.
Example: Imagine I just gave you $100,000 with the following two choices: I will either guarantee you an additional $50,000, or I will allow you to flip a coin. If you can call the flip, you can win another $100,000. But if you are incorrect, you get nothing more than the original $100,000… In other words, if you choose to take the guarantee, you are certain to get $150,000. If you choose to flip, you can get either $100,000 or $200,000.
Which option would you choose? Most people choose to take the certainty and walk away with $150,000.
Now suppose instead I gave you $200,000 with the following two choices: I will either guarantee that you lose $50,000 of the $200,000, or you can flip a coin. If you are incorrect, you will lose $100,000. But if you can call the flip, you will lose nothing…
Which option do you choose? Most people choose to flip the coin.
In both situations, you wind up with $150,000 if you choose the guarantee. In both cases, you have a 50/50 chance of ending up with either $200,000 or $100,000 if you flip the coin. The statistical odds are the same.
Most people choose the guaranteed $150,000 when they stand to gain. But it is a very different story when they stand to lose. Most people take more risk to avoid losing, than they do to achieve gains.
2. Confirmation
Confirmation bias describes our underlying tendency to notice, focus on, and give greater credence to evidence that fits with our existing beliefs.
Example: Consider the contentious debate over gun control.
Sally is in support of gun control. She reads news stories and opinion pieces that reaffirm the need for limitations on gun ownership. When she hears stories about shootings in the media, she interprets them in a way that supports her existing beliefs.
Henry is opposed to gun control. He reads news stories and opinion pieces that reaffirm the need for gun ownership and self-defence. When he hears stories about shootings in the media, he interprets them in a way that supports his existing beliefs.
These two people have very different opinions on the same subject and their interpretations and conclusions of what they read are based on their own beliefs. Even if they read the same stories, their biases tend to shape the way they perceive the details, further confirming their beliefs.
3. Hindsight
The hindsight bias is our tendency to look back at an unpredictable event and think it was easily predictable. It is also called the ‘knew-it-all-along’ effect.
Example: A stock goes up and an investor feels he “knew it all along”, when in fact the outcome was unpredictable.
4. Recency
Recency bias is the tendency to remember the first piece of information we encounter better than information presented later on.
Example: When you try to remember something from a long list of words, you tend to remember words listed at the beginning, instead of the middle. Recency bias helps to recall information you see first better than information presented later on.
To cater to this cognitive bias, companies often use television, radio, internet, and print advertising to present us with the first impression of their product or service, even before it is available. Additionally, this technique is used in news stories about upcoming phone releases or movie previews. There is often an incentive to make sure the first news you hear about a product is positive.
5. Framing
The framing effect is when our decisions are influenced by the manner in which the information is presented. Equivalent information can be more or less attractive depending on how it is presented.
Example: John is shopping for disinfectant wipes at his local pharmacy. He sees several options, but two containers of wipes are on sale. One is called “Bleachox” and the other is called “Bleach-it.”
Both of the disinfectant wipes John is considering are the same price and contain the same number of wipes. The only difference Jon notices, is that the Bleachox claims to “kill 95% of all germs,” whereas “Bleach-it” says: “only 5% of germs survive.” After comparing the two, John chooses the Bleachox wipes. He doesn’t like the sound of germs ‘surviving’ on his kitchen counter.
John’s decision to buy the Bleachox over Bleach-it wipes was guided by the framing effect. Although both products were equally effective at fighting germs, and essentially claimed the same thing, their claims were framed differently. Bleachox highlighted the percentage of germs it did kill (a positive attribute), whereas Bleach-it highlighted how many germs it did not kill (a negative attribute).
6. Endowment
The endowment effect describes how people tend to place a higher value on items that they own than on items that do not belong to them. This means that sellers often try to charge more for an item than it would cost elsewhere.
Example: A ticket to attend the Superbowl cost $1,000. Assuming you do not have one, you are asked how much you would pay for a ticket to attend the Superbowl. You are also asked how much you would sell your Superbowl ticket for, assuming you had a ticket. Notice the difference in the answer.
In a study by Ziv Carmon and Dan Ariely, results show that the selling price you choose places more significance on the event itself, while the purchase price you choose places more significance on the cost of the original face value of the ticket.
7. Self-Control
Self-control bias (really, a lack of self-control) is the tendency to consume today at the expense of saving for tomorrow. Money is an area in which people often lack self-control.
Example: A taxpayer knows for certain that they must pay exactly $7,200 in income taxes in a year. The taxpayer has 2 choices: 1) they can contribute $600 per month over the course of the next year to a savings account earmarked for tax season. Or, 2) they can increase income taxes withheld from their pay by $600 each month, thus avoiding the responsibility of writing out one large cheque at the end of the year.
Rational economic thinking suggests that the taxpayer should prefer the savings account approach since the money would accrue interest and would actually be more than $7,200 at the end of the year. However, many taxpayers choose to withhold their income taxes at source, because they realize that the savings account plan could be compromised in practice due to a lack of self-control.
8. Optimism
The optimism bias refers to our tendency to overestimate our likelihood of experiencing positive events and underestimate our likelihood of experiencing negative events.
Example: Tom is a bright and motivated entrepreneur who is starting his own restaurant. There had previously been six failed business attempts in the building he purchased. Each venture was unable to get the necessary returns to stay afloat and were forced to close.
However, Tom felt as though he had what it took to make this restaurant succeed. He was at the top of his class, full of big ideas, and understood the pulse of young city-goers.
Tom pours his time and financial resources into the venture, refusing to accept failure as an option or yield to potential shortcomings. A friend even tells him that the street layout and surrounding competition simply made it difficult for pedestrians to be drawn into the area. Yet Tom still feels that with his know-how, he can circumvent these issues.
However, like the businesses before his, Tom’s restaurant is not cultivating enough business. In this scenario, Tom exhibits the optimism bias.
9. Regret Aversion
Regret aversion occurs when a decision is made to avoid regretting an alternative decision in the future. Regret can be a powerless and discomforting state and people sometimes make decisions in order to avoid this outcome.
Example: Have you ever made a choice where you were explicitly aware of the influence of potential future regret on your decision-making? This could be the backpacking trip through Europe that you had to do because one day you might regret not going. It could be that impulsive purchase during a limited time offer where you tell yourself, “I know if I don’t get it, I’ll probably regret it later.”
While sometimes this sense of regret can just be a rationalization for a certain decision, it can also be a strong emotion that guides your preferences. And while such decisions driven by regret aversion can lead to ideal outcomes, they can also lead us astray.
10. Status Quo
When given the choice between simply leaving things as they are or actively making a change, we generally decide to let things be and do nothing. Status quo bias is also known as default bias, because it refers to our aversion to deviating from the status quo.
Example: Status quo bias can cause us to remain loyal to our advisors, brands, or stores, even though there may be better alternatives out there. When we buy a certain brand or shop at a certain store reliably, it becomes habitual. We may think that we make these decisions because we actually really like that brand or that store but, often we’re settling out of convenience.
So, did you learn anything about yourself?
You can find Part 1 and past publications at https://www.adamschacter.com/blog-1.
In part 3 of this segment, we’ll be looking at the 8 personality types.
The take-home here is to ensure you have a framework for long-term investing, and to ensure your emotions, biases and heuristics don’t cloud your judgment in sticking to that framework.
If you have any questions about your financial plan, would like our opinion on what this current financial landscape means for long-term investors, or would like a refresh on the framework we have in place for times like these, please never hesitate to reach out.
We are available and accessible to you any time through email, phone, or teleconference (video).
Be well and be safe,
Adam
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