The Psychology of Investing Biases - Part 1: Beware of System 1

Psychology BannerIn Daniel Khaneman’s instant bestseller, Thinking, Fast and Slow, he describes how the modern human mind has evolved to operate in two systems. He writes that System 1 is quick and instinctual, like when we answer basic questions such as 2+2 or complete automatic tasks such as walking to the couch with a cup of coffee while grabbing the remote to turn on the TV. System 1 runs the hundreds of small tasks needed on a regular basis in a quick and automated fashion.

System 2, on the other hand, is slower, more detail-oriented and methodical. It is usually saved for problems like answering 24x36, trying to figure out the seating arrangements for a wedding, or other tasks that require some level of thought due to their complexity or unfamiliarity.

If we needed to consciously consider every aspect of our lives, we would either have evolved with a much bigger brain (complicating childbirth), or we’d have a tough time getting anything done given the sheer amount of conscious consideration required. Instead (and fortunately), we are designed for efficiency and System 1 frees up our mind and energy for tasks that require careful reasoning.

Although we need both systems to run our lives, our natural inclination to become as efficient as possible is often problematic. It allows System 1 to make snap decisions and judgments when deep thinking and consideration is really required.

So why the diatribe on how our minds work? Over-reliance on System 1 leads to flawed thinking resulting in subconscious biases, particularly when it comes to the random and unpredictable world of investing. Given our relative inexperience with investing as a species, it’s one of the areas where our natural instincts are most apt to lead us astray.

The rest of this blog, and the next two parts, will cover biases investors are most susceptible to. It’s by no means exhaustive, but focuses on the prominent ones I’ve noticed through my extensive experience and research.

Over-confidence (the mother of all biases)

Most people would consider confidence as something to strive for. It raises our self-esteem, increases our influence, and gives us the energy and gumption to try new and exciting things. However, like always, too much of a good thing can be dangerous.

Most areas of life are influenced by varying degrees by luck and skill. The more closed (limited number of variables) a system is, the higher the skill to luck quotient is, which lends to System 1’s instinctual thinking. For example, chess masters can glance at a board and know that black is three moves from checkmate. Often they aren’t aware they’re doing this, but it’s due to the hundreds of hours and practice on a game with 64 squares, 16 pieces, and fixed rules. These factors don’t change, so the more they practice, the more they can lean on their instinct, or System 1, to guide them.

Investing on the other hand is a very open system. There are literally tens of thousands of butterfly effects (interest rates, geopolitical concerns, country and individual debt levels, income inequality, supply and demand, weather, accidents, management ability, competition etc.) that can heavily influence future outcomes. In open systems, one can still develop a high degree of skill, but the sheer number of factors that can affect a security reduces the amount of predictability of an outcome. This randomness reduces the skill to luck quotient. It doesn’t mean investing is devoid of skill, but it’s much more influenced by luck, especially in the short term.

Unfortunately most investors are unaware of the skill to luck ratio and are prone to over-confidence after a string of successes. Consequently, the more confident they become, the more risks they take. Although all of us are susceptible to over-confidence, men on average tend to be more prone to over-confidence than women.

Suggestion: Remind yourself that luck can, and usually will, influence investment returns; you cannot afford to become too confident and allow that to influence your behaviour.

Social proof (herd mentality)

Social proof or herd mentality has likely been around since the beginning of time. It’s natural to feel better when you’re taking the same action as everyone else. It’s likely this mentality was passed down through the ages as there was an evolutionary advantage for groups or communities that worked together towards a common goal, or against a particular threat.

In today’s world, our options are not only far more numerous, but also not as cut and dry as they used to be. This complexity, which resulted in Systems 1 and 2, often leads individuals to be heavily influenced by the cues signaled by a larger peer group. This of course means many of us fall in line on a whole host of factors without adequate thought and consideration. The “everyone can’t be wrong” thought pattern not only lowers our guards, but also makes us feel like we’re wrong if we’re different.

When herd mentality takes effect in the stock market, things really start to get out of whack given its huge reach. The classic case for this was Nortel. Leading up to the year 2000 during the boom, Nortel’s stock rose in an almost mythical ascent. For a while, virtually everyone who invested in the stock made money — and a lot of it. At its peak, Nortel’s stock value comprised almost 35% of the entire Canadian stock market’s value. A huge percentage of Canadian investors owned it, as well as, almost every Canadian equity mutual fund. How could they all be wrong? What’s most incredible is that Nortel was never profitable in those years. It was actually losing money. The bubble was created on speculation and anticipation of how dominant it would be in the future.

Nortel is merely a footnote in the financial history of the world. From the Dutch tulip bubble to the U.S. housing bubble, we as a society have created bubble after bubble only to see many of them burst into the ethos.

Suggestion: Always ask yourself or your advisor questions like, why do we own this security? Are we buying this because we know a lot of other people have made money on it?

Pride and regret (get-evenitis)

Research has shown that we have a natural inclination to overvalue things we currently possess. Known as the endowment effect, it makes a lot of sense from an evolutionary perspective. By placing an increased level of value on things they considered theirs, which included friends, family, and tribe, our ancestors increased the cohesion of their group and made it more likely to work and fight for the wellbeing of each other. However, in today’s world, this possessiveness has its drawbacks, especially when it comes to your portfolio.

When someone has an investment worth considerably less than they paid for it, they can often have strong reactions. Their perception is that it is worth more than the market is telling them it is. Moreover, if they sell the security at a loss, they will have to admit to themselves and often the world, that they were wrong, which can be very painful. By not selling, they are remaining consistent to their belief of the investment’s actual value, while also giving themselves a chance to break even.

Get-evenitis becomes even more problematic when an investor buys more of the security at a lower price (as it’s clearly worth more in their mind), thinking it’ll be easier to break even. This is not to say adding to a position is always a bad idea — markets often revert to mean as they go through cycles. However, given the unpredictability of investing, this decision needs to be based on careful evaluation rather than deferring to a System 1-induced blindness!

Suggestion #1: Ask yourself, if I never owned the security would I buy it now? If the answer is no, then it may be best to sell it while you can.

Suggestion #2: Always try to remember that just because you are down on an investment, it does not mean you have to make your money back on it.

My next post will cover the next three biases we’re subjected to: the halo effect, considering the past, and mental accounting. Stay tuned!