"The laws of probability, so true in general, so fallacious in particular."
Thank you for joining me for my eleventh blog in the series, highlighting decision-making and the brain. This is my public exploration of what drives decision-making and how we can use that information to make better decisions, resulting in better outcomes.
Today we are going to talk about how we perceive risks and how that perception might lead us to make poor financial decisions.
Four common financial biases:
1) Selling your stocks that are doing well
2) Not selling your stocks that are doing badly
3) Taking out insurance too frequently
4) Buying lottery tickets
plus we all seem to hate uncertainty in its many guises
At the face of it these are all very different animals with different causes, but they happen to all weave together in analysis that Daniel Kahneman (the author of Thinking Fast and Slow) put together. In the same way we feel losses more keenly that we feel gains, we feel differently about risks than the probabilities might suggest. These biases can be observed in real life but can be very well observed in the financial markets.
The most common financial bias that can be gleaned from individual trading accounts is that people sell their winners (stocks that have gone up in price) and do not sell their losers (the ones that have gone down). This is a systematic bias and many of those of us who do it dress up the bias in sensible language. Selling a winner is ‘taking chips off the table’ (who can argue with that). Not selling losers is ‘letting the thesis play out’ (sensible right?).
How we "feel" vs the actual probabilities
Source: "Thinking Fast and Slow"
I promised to make this blog accessible to all, but really think it is worth the mental gymnastics and look at the chart to make this point. We do not have a great intuitive feel of probabilities. The reason is because we as humans have both a rational mind where we understand probabilities, but also a physiological reaction to risk and uncertainty. This means that our subjective feeling about probabilities might not follow the pattern you would expect.
The chart above tries to cut to the chase by charting how you feel versus the actual probability and it significantly deviates. This difference between the actual probability and how you feel about it, might make you do something that is not strictly rational.
Humans hate uncertainty
The first takeaway is that if the probability of an event happening is 40% or more, we can see that humans undervalue a risky bet e.g. whilst a coin toss is a 50/50 outcome, if you were told you would win £1 if you guessed heads or tails correctly, you would only value that as 40p not 50p as would be the expected value.
This numerically shows that humans really do not like uncertainty and actively pay up to avoid certainty. We can see this in flights where people who value the certainty need to pay up vs someone who is willing to take the uncertainty (and hassle) of getting a deal at the last minute. We also see this in the financial markets - the markets often react more negatively to an uncertain outlook than a certain but bad outcome.
Higher probability events
This dislike of uncertainty i.e. over-discounting likely events, leads to two visible impacts:
1) Selling winners: Our minds over-discount a potential paper profit, and in order to produce a certain outcome we cut short our investment horizon to 'bank' a profit
2) Not selling losers: In last week's blog we described loss aversion, which sometimes leads to people taking unnecessary risks. In investing, to avoid crystallising a loss we try and hang on to the investment until it regains its entry point, but this is illogical, as your entry point is irrelevant to the value of a security. By not taking a loss, you stay in an unsuitable investment for longer than you need to.
Lower probability events
I am unashamedly going reprint the chart so we go back to the other effect that can be seen from this chart. We feel unlikely events more than their probabilities suggest.
1) Over-insure: Before I start the over-insuring point, it is important to note that it is sensible to take out home insurance (particularly the building insurance) as it could potentially be financially ruinous if your house was irreparably damaged and you had to pay to rebuild it. However, in most other types of insurance, people tend to over-insure i.e. take out insurance where, if they stopped insuring low value items, in the long run, they would likely save more money on insurance than they would lose on replacing goods.
In my opinion, it rarely makes financial sense to take out extended warranties or get insurance for things that would not be ruinous for you to replace.
More broadly in life, we can see this when people overly focus on a small thing, and lose sight of how meaningful the point is in the big picture (e.g. nit-picking).
2) Buy lottery tickets: People ‘feel’ a higher probability of gain than probability should have you believe. This encourages people to buy lottery tickets. Whilst I am partial to a flutter, I see it as a cost of entertainment and excitement rather than a financially-driven transaction. If you really want to win the lottery, start a lottery and win every week!
The key takeaways from today are:
1) Humans do not approach risk in a completely rational way, and feel differently about situations than their probabilities would suggest
2) This in general leads to having a higher perceived effect than the probability would suggest for unlikely events and a lower perceived effect than the probability would suggest for likely events.
3) These financial behaviours COST YOU MONEY. By understanding and being mindful of these innate biases, we make better financial decisions. If you invest in the financial markets, you can train yourself to be a better decision-maker for the risks you are taking.
Thank you for joining. Next week will be a list of books for any budding decision-maker.