The brain is a marvel of complexity. It orchestrates millions of neurons just to navigate the simplest decisions. On average, we make 35,000 decisions a day.
Behavioural economist Daniel Kahneman theorized two basic modes of thinking for decision-making. The first is rational thinking—based on thoughtful evaluations resulting in logical conclusions. We use this system for only 5% of our daily cognitive activities.
The second mode is intuitive thinking. To cope with thousands of daily decisions, we rely on heuristics—mental shortcuts shaped by past experiences and habits. These heuristics streamline decision-making but often at the cost of accuracy and detail, leading to cognitive biases.
Biases and Heuristics in Investing
Whilst intuitive thinking feels right, its not always logical. Here are some of the most interesting heuristics and biases that affect investing decisions:
Anchoring Heuristic
We intuitively think that recently acquired information is relevant when making a decision, even if outdated. Our perception of value is based on reference points and as a result, investors base their valuations on past prices even when fundamentals shift.
Confirmation Bias
Our thinking is biased towards interpreting information in a way that confirms preconceptions. We seek out news that supports our views, creating echo chambers in process, with personalised social media algorithms only exacerbating the problem.
Herding Bias
Humans are social creatures. Prone to following the crowd, often imitating the collective actions of others who possess greater knowledge or expertise. The Herding bias fuels narratives which exacerbates further herding, driving up prices and occasionally inflating bubbles. Retail investors often trail ‘smarter money’ and the safety of the herd.
Narrative Fallacy
Stories evoke emotions and engage our imagination, making them more compelling than raw data or abstract concepts. We’re drawn to narratives that resonate with our values, fears, and desires. As a result, we’re swayed by market narratives that promise high returns, yet rationally we understand this doesn’t always align with reality.
Hindsight Bias
Our thinking is biased by the illusion that past events were as predictable at the time they happened as they are now. It provides many a sense of control of events, allowing us to believe we could have predicted or controlled outcomes had we acted differently.
Availability Heuristic
We tend to favour recent examples that come to mind when making judgments. We intuitively think the things we remember are more likely to happen again and therefore they’re more important. The reason being that the attributed importance is based on the ease they can be retrieved from memory.
Sunk Cost Fallacy
The continuation of an investment because of the resources already invested, even if the current costs outweigh the benefits. Rather than minimizing losses, they often view abandoning the investment as a personal failure for not seeing it through to the end.
Loss Aversion
The tendency to strongly prefer avoiding losses over acquiring gains of the same magnitude, leading to risk-averse behaviour and the reluctance to take actions that may result in losses. Prospect theory suggests that individuals are risk-averse when facing potential gains but become risk-seeking when trying to avoid losses.
Beware the Bias
Investing is a tricky dance of biases and emotions; while the allure of familiar ground and the comfort of hindsight are tempting, they should not dictate your financial journey.
To navigate these deviations in logic, Kahneman suggested the following: acknowledge your biases, as recognizing how they might affect your investment choices is crucial; beware of emotional investing, since fear and greed can cloud judgment.
Stay curious, question narratives, and always look beyond the obvious.
