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 anti-nuclear demonstrations.
In a 1983 study, psychologists Daniel Kahneman and Amos Tversky provided a group of people with a list of 8 occupations and asked them to rank Linda’s likely occupation based on the fictional profile outlined above. The occupation of bank teller ranked 8th out of 8 – dead last.
Kahneman and Tversky took this result and created a follow-up question: which of the following is more likely?
- Linda is a bank teller
- Linda is a bank teller and is active in the feminist movement
The overwhelming majority of participants selected #2, despite the fact that it is literally impossible for it to be correct unless #1 is correct.
Our brains are wired to visualize, and the more lifelike the image, the more we cling to it. The addition of descriptive details allows our mind to paint a more vivid picture of the concept we are wrestling with. Naturally, we seek additional details to support the story unfolding in our minds.
This is the mechanism that allows us to “get lost” in a great novel and bring the story to life. A great novelist is an expert at using words to produce images in our minds. We actually see the story unfolding in our brains as we read the words on the page. It is a very cool ability we have been blessed with as human beings. However, this wiring can severely impair our judgment and decision-making.
In the case of Linda, it was difficult for participants in this study to visualize her as a bank teller, but it became a lot easier to visualize her as a feminist bank teller!
In our financial lives, given the immense amount of information at our disposal today, it is easier than ever to paint a vivid image of whatever it is we think is going to happen.
If we want to believe that the market is going to drop, for example, we simply pick up any newspaper, financial journal or turn on the news and we are bombarded with excruciating details that explain why (and remember…research indicates that negative news makes an impression at least 3x that of positive news, which equates to 3x more advertising revenue for news outlets). Consider the following – which is more believable?
- The market is going to drop.
- The market is going to drop because Greece is a complete disaster, the Eurozone is not much better, unemployment in the US is still too high and things aren’t going to get any better because our politicians can’t even agree that a hockey puck is black.
Despite the mathematical fact that #1 is technically more likely (and we all know it!), the majority of people would choose #2. The second option painted a more vivid image of why the hypothesis may be true. In reality, there are hundreds of thousands of additional variables that we unconsciously ignore because they only confuse and cloud the clear vision in our minds. While there were absolutely no signs of a recovery in march of 2009, one incredibly enormous factor stood out among the rest – prices were low! The image in the average investor’s mind was terrifying at the time, as is evidenced by the massive outflow of dollars from stocks. They overweighted variables that supported their vision and underweighted or ignored those that didn’t.
Charlie Munger tells us that when considering a hypothesis or analysis, “always invert.” Bruce Berkowitz tells us that as he is evaluating a stock, he always attempts to “kill the company,” that is, figure out how it could fail. We must program our minds to attempt to kill whatever hypothesis we have concocted in order to evaluate it appropriately.
Recent research has outlined an incredible phenomenon. It will come as no surprise that most people try to read with an open mind. After all, we read because we are attempting to learn something. Now go back to #2 and read the sentence with a furrowed brow. Notice anything different? When we read with a furrowed brow, we naturally start to question what we are reading (or watching, or listening to) instead of taking it verbatim. In doing so, we actually think about what we are reading instead of merely absorbing it.
There are hundreds of thousands of variables that account for the market’s gyrations in a given day, yet we cling to two or three of them because they paint a vivid story for us. Our brain literally tricks us into believing we understand something we really don’t.
Now consider how we buy homes (or cars, career paths, take vacations). We do some basic analysis on the front-end to determine the level of mortgage payments we can afford, then begin searching for homes in that price range. As we walk through the front door, our brains immediately begin to create images of our family living there. Not surprisingly, the story that immediately starts to unfold in our mind consists of images of the unwavering happiness we will share in each room of the house.
Naturally, we fall in love with the home first (we make an emotional decision right at that moment, whether we present an offer or not) and spend the following days trying to justify it. We spend time offsetting the things we don’t like with all the positive things we do like. We justify stretching our budgets a bit too thin by including expected (but unrealized) raises and bonuses into the projections. If that doesn’t work, we simply shave a few things we suddenly don’t need and magically, it works!
We unintentionally leave ourselves extremely vulnerable at times due to the way our minds work. People stopped working after the 1990’s, believing their portfolios would support them forever. Along similar lines, many got caught up in the housing craze of the last decade. As a society, we actually believed that everyone should own a home!
We must remember that every time the market (or a stock, a house, etc.) rises in price, future returns are reduced. This is not an opinion or a guess, it is a mathematical fact. When bubbles occur, they are simply stealing future gains, and the outsized gains that your neighbor already participated in can not be repeated. The same is true in reverse. Every time the market drops, future returns literally increase. Again, this is not a guess or suggestion, it is a simple mathemetical fact.
Details provide us with a dangerous platform to paint a more precise image in our minds. This precision provides a false confidence that leads us to make some poor decisions. The future is uncertain, no matter how vivid the image we can paint. Always remember, you are far better off being approximately right than risking that you might be precisely wrong.