How Healthy Are Your Heuristics And Are They Affecting Your Investments?

Investing wisely should be a mathematical exercise … but often, the real science at work is psychology.

If you say the words “stock market” to anybody, chances are the very first thing they picture is the jagged line of a graph showing ups and downs. The most fundamental fact we all know about investing is that, in the short term, values rise and fall seemingly at random. It’s literally iconic. What’s harder to remember is why: the irrationality of the human mind.

People buy and sell based on their conclusions, which can be derived from hard data … but also how they feel about all those acts and figures. Daniel Kahneman, a psychologist, won a Nobel Prize two decades ago in economics, for research that  “integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty.” In other words, he made a study of the unfortunate fact that human beings make decisions in an unbalanced way: We feel losses (and the fear of loss) much greater than gains (and the hope of gain). As a result, we tend to make decisions based on a logical fallacy he called “loss aversion.” Each loss, Kahneman found, can have twice the psychological impact as each gain, so people work harder to avoid losses. Naturally, this affects the way people invest — the heuristics they use to make decisions.

A “heuristic” is a rule of thumb, a shortcut our brains use to avoid having to work through the logic of every decision. Sometimes, they’re useful: “I keep hearing good things about that new restaurant, so it must be worth checking out.” But sometimes, they lead to stereotypes, biases, and faulty conclusions: “I keep hearing about plane crashes in the news, so most planes probably crash.” Both of those are examples of what’s called an “availability heuristic,” which just means “the information I have available to me is representative of all the possibilities.”

The heuristic Kahneman and his colleagues found, “loss aversion,” can be even more misleading. Think of it this way: An investor who starts the year with $200,000 and ends the year with $270,000, making profit steadily month after month, is pretty satisfied with their strategy. Another investor who starts the year with $200,000 and by July rockets up to $320,000 but then loses $50,000 to end the year at $270,000 has had just as good a year. $200,000 became $270,000. But that second investor is likely to rethink all their choices, question their strategy, and feel an urge to change the way they do things … all because that $70,000 gain came with a $50,000 loss along the way.

“. . . not having any losers isn’t a useful goal. The only sure way to achieve that is by not taking any risk. But … risk avoidance is likely to result in return avoidance. There’s such a thing as the risk of taking too little risk. Most people understand this intellectually, but human nature makes it hard for many to accept the idea that the willingness to live with some losses is an essential ingredient in investment success.”     -Howard Marks, Oaktree

Emotional investing is a well-known trap, which can be avoided if you’re rational enough to understand that this is how all human brains work, perceptive enough to account for tricky heuristics like loss aversion in your investment strategy, and cool-headed enough to stick with that strategy when these involuntary biases threaten to take you off course.

Here are some of the other less-than-helpful heuristics that experienced investment advisors can recognize and help investors be aware of.

HOT-HAND HEURISTIC:

Sports fans and casino gamblers know this as a “streak,” the idea that someone who has performed well in the last few games will continue to rack up wins. It feels like someone who guesses four coin tosses in a row will keep guessing correctly because they must be doing something right. They’ve got a hot hand, right? In fact, each coin-flip has the same 50% chance. A related fallacy is known as the Gambler’s or Monte Carlo Fallacy: the idea that a series of gains makes a loss more likely. In fact, luck is not something finite that runs out. A random action remains random, no matter how many times you repeat it, and a stock that rises and rises can continue to rise if all other conditions remain the same.

SUNK-COST FALLACY:

This one should be familiar to business owners. A “sunk cost” is money that has been spent and can’t be recovered. The fallacy is the idea that, since you’ve already spent so much on the project, it has to only take a little bit more to “get over the hump,” turn things around, and make it all worthwhile. In fact, decisions about the future should only take into account future costs as well as potential profits. Don’t use “I’ve already committed resources” as a reason to keep committing more resources.

 TEXAS SHARPSHOOTER:

This is related to a heuristic called “anchoring and adjustment.” Picture a gunslinger shooting the side of a barn, then walking up and painting a bullseye around each bullet hole. Someone coming along later might be astounded at the pistolero’s accurate aim, disregarding the fact that there was a whole lot of barn that didn’t get hit, and didn’t have any circles drawn around it. In other words, people pay (and draw) attention to successes, while failures tend to be ignored — even if there are a whole lot more failures than successes. Once we see an accomplished goal (or “anchor”), our brains tend to collect information that makes it seem intentional, “adjusting” our information to fit that narrative.

THE BROKEN WINDOW:

This was first spelled out by French economist Frederic Bastiat, who told a story of a boy in a small town who broke a window. The townspeople, surveying the damage, decide that the boy has actually done a service to the town, since his father must pay to have the window repaired, so the hardware store owner and the glazier will both be wealthier and spend more money in other local businesses. Having reached this conclusion, they all start breaking windows. In fact, the money and time the boy’s father spent to repair the broken window took more out of the economy than the glazier and store owner made. The same principle explains why war doesn’t really stimulate the economy. Maintenance costs (like repair) might feel like short-term gains, but over the long term, the costs more than add up.

There are plenty of other fallacies to which unprepared investors can fall prey. However, a well-made investment strategy, with regular check-ins to make sure every change in context is accounted for, should keep delivering decent returns over the long run. If you’d like help keeping your long-term plans free of the dangers of unhelpful heuristics, have one of our investment advisors talk things through with you.

Sources:
A: Kahneman https://www.nobelprize.org/prizes/economic-sciences/2002/kahneman/facts/

B: Loss aversion: https://en.wikipedia.org/wiki/Loss_aversion

C: Mitch Zacks loss aversion article (pasted below)

D: Hot hand: https://www.investopedia.com/terms/h/hot-hand.asp

E: Gambler’s Fallacy: https://www.investopedia.com/terms/g/gamblersfallacy.asp

E: Sunk cost: https://www.investopedia.com/terms/s/sunkcost.asp

F: Texas Sharpshooter: https://www.investopedia.com/terms/t/texas-sharpshooter-fallacy.asp

G: Anchoring and Adjustment: https://www.yourdictionary.com/articles/examples-heuristics-everyday