Investment Matters

Thinking slow

Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues relating to the environment and social justice. Which is more likely?

 

A. Linda is a bank teller

B. Linda is a bank teller and is active in the climate change movement.

 

If you answered A, you would be in the minority. You would also be correct - adding an additional, narrower condition means B will be less probable.

The question highlights one of many cognitive biases - systematic errors we have in our thinking.

When faced with volatility or exuberance, markets tend to drift towards these biases.

Cognitive biases have also contributed towards some of the worry around the current market rally. 

 

A wall of worry

A market rally is not often a peaceful place.

When markets rally, participants often wonder how long the rally will continue and whether a rally has become “extended”.

This goes hand in hand with being an investor and these questions should be asked, as a range of outcomes are always possible.

However, the current “wall of worry” also reflects our cognitive biases.

 

Thinking fast

Kahneman and Tversky in “Thinking Fast and Slow” divide our thinking processes into two types.

Fast Thinking: which is reactionary, automatic, intuitive, and largely unconscious - relying on heuristics and pattern recognition.

For example, complete the sentence: “Bread and…..” [butter]

Slow thinking: the slower, deliberate, analytical form of thinking that requires conscious effort to reason about the world.

There has been a tendency to let Fast Thinking creep into our thought processes in recent times – we have been grappling with a significant amount of change: economic, social and political.

Yes, Fast Thinking can be helpful. It is the type of thinking we use the most for simple problems and in making simple decisions. However, it also leads us to jump to conclusions.

This is fine when these conclusions are likely to be correct and the cost of making an error is acceptable.

However, it makes our thinking prone to error and bias, particularly in situations that are unfamiliar. This is part of what builds the wall of worry.

Biases Explanation
We struggle with probability.

It is difficult to intuitively grasp uncertainty. We therefore gravitate towards strong and “absolute” views. In reality, the future is better thought of in terms of probabilities and outcomes rather than one central prediction.

Availability heuristic

A tendency to rely on the first piece of information we are presented with when making decisions. For example, it is difficult not to anchor our views in the economic data and market commentary that has been presented over the past few months – such as higher unemployment and rapid declines in GDP. A rising market therefore feels unnatural.

Affect heuristic

At times, opinions are heavily coloured by how we feel. This has been particularly powerful during COVID-19, as the market has rallied ahead of our lives returning to normality. 

Representativeness heuristic

People reach for past examples when trying to explain the future in an attempt to categorise the events of today. For example, market commenters will try compare the present to periods in history ranging from the Great Depression to the bull market of 1984. While history provides us with enduring lessons and insights, the future is rarely a repeat of the past and needs to be interpreted through slow thinking.

Confirmation bias

Faced with uncertainty, we can seek refuge in prior contentions. It can be easy to interpret information in a way that confirms pre-existing beliefs. It is easier to seek out information that reaffirms our views than to change or challenge them by acknowledging conflicting data points.

   

Thinking slow

Most problems in investing relate to the future. This involves predicting possible outcomes with a data set that is incomplete. Furthermore, situations are often unfamiliar. This requires a conscious focus on slow thinking.

Slow thinking is mostly detached from emotions. It is controlled, is able to embrace a high degree of complexity but takes time and requires a high degree of effort.

While our gut feel might tell us something is wrong, it is slow thinking that should be the basis of our decisions.

Conclusion

There is always a wall of worry the market has to overcome during a market rally.  

We have endured a confronting period of change which has amplified the tendency for fast thinking and has made current the rally feel strange.

Uncertainty is and always will be a part of investing.

However, we are better served interpreting it through deliberate, slow thinking.