Do you remember the Vulcan character, Mr Spock, frequently saying “highly illogical” on Star Trek? It’s such a famous line that someone even wrote a song about it, as shown in the fun video below.
It’s true that human beings are sometimes illogical, and there’s even a theory that supports this notion. It’s called the Gell-Mann amnesia effect. The theory states that people tend to believe stories in the media even when they’ve just read an article about their field of expertise that’s riddled with errors. You can read more about it on Wikipedia.
We’re always reminding you to ignore the media hype when it comes to your investment planning. Don’t believe what they say, and don’t get taken in by their excitement or panic.
OK, so there’s a certain irony here because we write articles about investment too. For example, last month we wrote an article, Hot off the press, about the disgraced Woodford fund. That’s because we like to keep you up to date (because our clients asked us to). Not because we think you should change your plans because of it.
This is not the only area where our minds play tricks on us. Here are a few more…
Confirmation bias: We tend to seek out people and information that confirm the way we think. For example, a 2009 study by Ohio State University found we spend 36% more time reading an essay that aligns with our opinions (so we hope you’re still reading this).
Swimmer’s body illusion: This illusion occurs when we confuse selection factors with results. Professional swimmers are good at swimming because of their physiques, not just their training. For example, do the best universities get good results because they choose good students, or do they get good students because the universities are good?
In the investment world, many people assume that active fund managers must know something they don’t, when that’s simply not the case. We’ve written about the danger of that assumption many times before.
Sunk cost fallacy: We feel loss more strongly than gain. So, if you’ve invested time, money or effort into something, and it can’t be recovered, it hurts. This prevents us from realising that the best choice is whatever promises the best future, not the one that negates the feeling of past losses.
This means when an investment is gone, it’s gone. You can’t get it back, so let it remain in the past and move on.
Gambler’s fallacy: We predict odds incorrectly. Imagine you’re tossing a coin and predicting whether it will land head side up or tail side up. If it turns up tails six times in a row, you might think, “it’s sure to be heads next” – yet the odds remain the same at 50:50 every time (assuming it’s an unweighted coin). This connects with a gambler’s positive expectation bias. That is the thought that your bad luck has to change sometime.
Don’t take a gamble on the markets going up or down in the short-term. The only sure thing is that they go up over the long-term.
Cognitive dissonance reduction: We experience discomfort (dissonance) when we try to hold two competing ideas at the same time. So we try to reduce it, either by changing our behaviours or by changing our thoughts. Imagine you’ve gone on an impulse shopping trip and bought some ill-considered items. Afterwards, you’ll tell yourself you really needed them, until your thoughts align with your actions. This is called Post-purchase rationalisation. We’re good at convincing ourselves that our ill-considered purchases are necessary after all. Either that, or you’ll return them to the shop to reduce the cognitive dissonance you feel.
Availability heuristic: This means we believe our memory more than facts. Yet memory is highly fallible. For example, when asked if there are more words ending with ‘ing’ on a page, or more words with ‘n’ as the second to last letter, most people say there are more ‘ing’ words because those are easier to remember. It’s harder for us to recall words that have ‘n’ as the penultimate letter, so people tend to assume there aren’t as many on the page.
Don’t base your decisions on gut instinct without exploring all available data first.
Comparative value: Rather than making a decision based on value alone, we factor in how it compares to another option. For example, The Economist offered three choices: web version $59, print version $125, or both for $125. Of 100 MIT students, 84% chose the combo deal, 16% chose the cheaper, web-only option, and nobody chose the print-only option. When the ‘useless’ print-only option was removed, the majority chose the cheaper, web-only version, and the minority chose the combo deal. So, the bad-value $125 print-only option wasn’t actually useless, in fact, it informed the decisions people made by making the combo deal seem more valuable by comparison.
If this fascinates you as much as it does us, you might like to watch the TED talk by behavioural economist, Dan Ariely: Are we in control of our own decisions?
What this means to you
You will make more rational decisions if you can avoid these mistakes in your thinking. The best thing you can do is:
- Choose low-cost funds
- Diversify broadly
- Stick with your investments long-term, no matter what happens with the markets
As you can see from our company slogan, the Tucana approach is about giving personalised advice backed by science. The particular aspect of science we talk about is called behavioural finance. (We’ll write more about that next month.)
P.S. For more on this subject, you might like to read (or re-read) our article What’s the point?