Traditional economic theory suggests human beings behave rationally when making decisions. In other words, humans, on average, act in such a way as to maximize fulfillment of their needs and desires. Since earning wealth is assumed to be a good thing, and more wealth is assumed to be better than less wealth, it is further assumed that people make rational decisions in order to maximize their wealth. This rationally acting person is sometimes referred to as Homo Economicus (Economic Man).
However, traditional economic theory often does not match how people make decisions in the real world. Research into Behavioral Finance, led by Nobel laureates Richard Thaler (for Economic Sciences in 2017) and Daniel Kahneman (for Economic Sciences in 2002) has revolutionized the way we think about how people make financial decisions. Instead of being purely rational humans that dwell exclusively in the minds and models of economists, behavioral economists have shown that mankind’s decision making is heavily influenced by emotion and irrationality. However, the real insight isn’t that people make decisions in an emotional and irrational manner, but rather we are all predictably irrational.
Human beings crave certainty and are comforted by feeling right. When we feel certain and right we feel a sense of security and comfort. In order to get this sensation, which is called cognitive ease, we seek out information that is familiar, easy to understand, and validates our pre-existing beliefs. Humans have developed a number of mental shortcuts that help us understand the world while maintaining as much cognitive ease as possible. These good enough mental shortcuts, or heuristics, while not optimal or perfect, are often sufficient to meet our immediate goals. While heuristics ease our cognitive load, they can also lead to cognitive biases that by their very nature are distortions or errors in thinking. Heuristics allow us to experience a sense of cognitive ease, which makes us feel good, but distortions and errors they cause can actually decrease our understanding of the world.
Nobel laureate Daniel Kahneman says our brain has two systems. The first utilizes heuristics and provides fast, intuitive responses that govern most of our daily lives. The second activates cognitive effort and is much more energy intensive. System one, the conscious part of the brain, is kind of lazy and doesn’t want to work more than it has to, so it is just fine with utilizing heuristics to make decisions and explain the world. It’s more than happy to let the unconscious part of the brain do all the work. Because these heuristics and the subsequent cognitive biases they engender operate at the unconscious level, we aren’t even aware of them unless we make a diligent effort to recognize them. In fact, even when confronted with the evidence, our first reaction is to deny that we have these biases. To be human is to have cognitive biases. In this year’s Investment Perspective, we will examine several types of cognitive biases, reflect on the errors they can potentially cause, and propose several methods of dealing with and overcoming these biases which affect us all.