Human beings have evolved over thousands of years and while many of our automatic behaviors (“system 1”) were fundamental in keeping us alive, they can impair some of our cognitive reasoning (“system 2”) functions in the modern world. While much has been written on this topic and we sight Nobel laureate, Daniel Kahneman’s excellent work for a deeper discussion on the subject, we will explore some of the day-to-day situations which are open to sub optimal and poor decision making in the context of investing.
Sunk-Cost Fallacy
People will naturally gravitate towards supporting an investment that they have lost money in, hoping a turnaround is on the horizon. The main reason for this is thought to be that the “pain” of losing is psychologically twice as powerful as the pleasure derived from gaining. In fact this natural bias of not wanting to crystallize a loss is deeply embedded in our “system 1” DNA, which Daniel Kahneman articulates in his very informative book, “Thinking Fast and Slow”.
“Organisms that placed more urgency on avoiding threats than they did on maximizing opportunities were more likely to pass on their genes. So over time, the prospect of losses has become a more powerful motivator on your behavior than the promise of gains” – Daniel Kahneman
In the famous 1985 experiment, Hal Arkes and Catherine Blumer demonstrated people’s natural tendencies blurred once they had to factor in “sunk costs”. In the experiment they asked subjects to assume they had spent $100 on a ski trip to Michigan, but shortly thereafter found a much better ski trip to Wisconsin for $50 and bought that trip too. Participants were then told that by mistake, the two trips overlapped and the tickets couldn’t be refunded or resold, forcing them to pick between the $100 vacation and the $50 one.
Interestingly, more than 50% of participants in the study chose the more expensive trip, despite knowing that it would not provide as much enjoyment as the less expensive option, effectively choosing the less valuable trip because they had paid more for it. The sunk-cost fallacy prevented participants from choosing the best option namely the trip which promised the better experience in the future, because the feeling of loss in the past overwhelmed that sense. In theory 100% of participants should have selected the better trip, as the cost of the trip was effectively $150 (total sunk-cost), hence the better product should have been selected. This is a fundamental perspective bias that good investors must keep in mind, despite having lost a significant amount of money in an investment, if there is a better use for that capital (i.e. a better investment) then one should cut losses and reinvest. This of course is very difficult in practice and similar to why people will sit through a terrible movie in the cinema in an ironic attempt to “get their money’s worth”.
Intuition is Bad at Probability
Picture yourself walking up to a roulette table at a casino, you look at the prior results and last 7 numbers have been red, surely this would mean the probability of a black number is now higher…right? This is known as the “gambler’s fallacy”, an illogical conclusion that manifests itself from placing too much weight on past events. Despite the fact that each spin of the wheel is an independent event with an equal probability of red or black, people often disregard this knowledge and believe they have spotted an “edge” in the data which is ripe to reverse profitably for them (i.e. come up black).
This fallacy extends itself into positive expectation bias as well, when a person mistakenly believes that eventually “luck has to change for the better”. People find it difficult to accept bad results and cut losses, instead continuing to persist until positive results are achieved, regardless of what the odds of that happening actually are. As value investors, we try and detach ourselves from recent performance and focus on the facts, a probabilistic range of outcomes and make our decisions based on impartial, emotionless judgement, secure in the knowledge that over time, this framework will deliver the best set of outcomes.
Stereotypes Impair Decision Making
As a final example of our minds playing tricks on us, we again look to Daniel Kahneman and his long-term research partner, Amos Tversky. In their 1983 paper, Kahneman and Tversky described the following imaginary person:
“Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice and also participated in antinuclear demonstrations.”
Following this description, the participants were asked a simple question:
“Which alternative is more probable?
- Linda is a bank teller
- Linda is a bank teller and is active in the feminist movement”
Roughly 85% of participants selected option #2 as the answer, however this answer can NOT be correct because answer #2 is a subset of answer #1, which by definition makes #1 a higher probability event (which was the premise of the question). In other words, if “Linda is a bank teller” then she may or may not be “in the feminist movement” which is covered by answer #1, while only a scenario in which she is in the feminist movement is covered by option #2 (lower probability, but 85% of people picked it!)
Our minds and its instinctual inclinations can indeed deceive our ability to solve even the most straight forward problem. The team at Montaka Global is acutely aware of natural biases that we are predisposed to, and our highly refined, fundamental, value investing framework seeks to normalize for these potential sources of error.
Amit Nath is a Senior Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.
