Sunday, October 2, 2016

We Are Not Always So Rational, Part 2

Recall from our previous post that we investors suffer from behavioral biases that lead us to make poor decisions. There are two main types:
  • Cognitive biases (resulting from lack of knowledge, faulty logic and memory errors) 
  • Emotional biases (making decisions based on impulse and feelings)
We discussed some cognitive biases already, so let’s take a look at the other type.

Emotional Biases

  • Loss Aversion (also known as Prospect Theory) – this is when we strive to avoid losses rather than seek gains.
An investor is said to be risk-averse if they feel more pain from a $1 loss than pleasure from a $1 gain (and risk-seeking if they feel more pleasure from the gain). If offered a stock and told there’s an equal chance of it either falling to $90 or rising to $100, the risk-averse investor would not pay more than $95 (ie. the expected value of the stock) while the risk-seeking investor would. 
An investor that is loss averse may initially be risk-averse, but when faced with losses, can become risk-seeking in an irrational attempt to climb out of the loss. The implications of loss-aversion are massive. They include:  
- Holding excessively conservative portfolios (eg. heavy in bonds or cash)
- Not selling losers in order to avoid a realized loss
- Trying to climb out of a loss by doubling down on losers or trading excessively  
  • Overconfidence Bias – Overestimating your own intuitive ability or reasoning. 
Example: Ask an audience how many think they are below-average investors and few hands will go up. In fact, studies show that 95% of us view ourselves as above-average drivers! Truly astonishing.
  • Endowment bias - We give greater value to things we already own or are familiar with. In investing, this leads to holding securities too long or in concentrated sizes. This is also related to the tendency for investors to concentrate their portfolio in their home country, as it's familiar. 
Example: You're deciding between a Toyota Camry and a Honda Accord and have no idea which is better. 6 months after purchasing one, that car becomes familiar and you say "I don't know what I was thinking even considering the other car!
  • Regret aversion - Making choices simply to avoid potential regret. People often do what others are doing in fear of being left behind, leading to the "herd behavior effect"
Example: During the NASDAQ bubble of late 90's, many individuals were buying into the market for fear of missing out. 
  • Status Quo Bias – Comfort with an existing situation leads to an unwillingness to make changes or consider other, better options. 
Example: Selecting the default asset allocation on an employer defined-contribution plan and not changing it with the passage of time. This leads to a portfolio with inappropriate risk
  • Self-Control Bias - Lacking self-discipline and favoring immediate gratification at the expense of not meeting long-term goals. Too many people do not save enough to fund retirement needs

We’ve now looked at 12 cognitive and emotional biases. This just scratches the surface as it turns out there are at least dozens more that we suffer from. The more you study our decisional flaws, you realize that we are nowhere near the rational, number-crunching computers that efficient market theory assumes we are.

Where do our biases come from?

Psychology identifies what our biases are while biology explains where they originate from. 

We humans evolved very slowly over 6 million years from more primitive origins. Each generation produced offspring with some genetic variation. Those with traits providing a better survival edge (no matter how slight) had higher probability of passing on those traits to the next generation. We were shaped in this progressive and cumulative process over millions of years (though the above picture makes you question the “progressive” part!)

The majority of our history was lived in a perilous world. Our traits are well adapted to suit this environment, helping us fend off predators, hunt prey, build shelter & tools, etc. It is only in the last 6,000 years (or 0.1% of our human history) that civilization as we know it has been around, and only 200 years (0.003% of our history) that we’ve been living in an industrialized world. In a very short period, we enjoyed a dramatic increase in our standard of living. Suddenly, we no longer needed to spend the majority of our time and energy worrying about our survival. 

Our mind and bodies, however, have not been able to keep up since evolution is a slow process. It can be argued that this has led to some major health issues we face today from: a sedentary lifestyle, radically different diet and constant barrage of information and interruptions to name a few. We especially are poorly equipped to manage our investment portfolio. Handheld phones with stock prices refreshing every second are sabotaging our ability to maintain a long-term mindset. 

Perhaps we may never fully adapt to this new world: our standard of living is so high that our biological imperfections don’t significantly hurt our chances of survival. You will still be able to eat even if your portfolio isn’t holding the right asset allocation or if you don’t understand what standard deviation is!

Evolutionary Psychology is a separate discipline that attempts to explain mental traits—such as memory, perception, or language—as products of natural selection. On the most basic level, we feel positive emotions (euphoria, excitement, confidence) when we receive things that increase our survival and replication chances. We feel negative emotions (fear, anger, panic, frustration) when it’s the opposite. 

Some of the behavioral biases we discussed can at least be partly explained by Evolutionary Psychology as follows: 
  • Loss aversion: "For an organism operating close to the edge, the loss of a day's food could amount to death, while the gain of an extra day's food could lead to increased comfort but (unless it could be costlessly stored) would not lead to a corresponding increase in life expectancy." - Wikipedia
  • Endowment bias and Status-Quo bias: you stick to what is familiar because it is safer and reduces risk. It could cost your life if you wandered into a new, unfamiliar part of the woods alone. 

So far in the series, we discussed several behavioral biases that cause us to make poor investment decisions and where these biases originate from. In the third (and last) part, we’ll look further into the impact of our biases on our investing as well as how we can minimize this impact. But first…

Quiz Time!

See if you can identify the behavioral bias in each Dilbert comic strip below. Answers can be found on my twitter feed (@sharpeReturns).


  1. Nice article. In my experience, investing is about 25% knowledge and 75% dealing with emotional and cognitive bias.

    Nick de Peyster

    1. Thanks and agreed! Discipline is highly underrated.


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