158. Human-ness — mighty weapon and also, our Achilles Heel (9. Building Finance Intuition)
“Odd as it may seem, I am my remembering self, and the experiencing self, who does my living, is like a stranger to me.” ― Daniel Kahneman
Wealth creation is a uniquely human preoccupation. I don’t think any other living being has to worry about accumulating wherewithal for their old age. Animals are permanently locked into the here and the now. They do not regret past actions, neither are they anxious about the future. Their primary pre-occupation is really engaging with the present. Of course, there are exceptions. For example, squirrels hoard a variety of nuts to be consumed during colder days when food is scarce. Even they, I believe, do not accumulate for the rest of their life…. their hoarding is a cyclical process…. nothing like retirement that we humans invented.
“We admit that we are like apes, but we seldom realise that we are apes.” — Richard Dawkins
I have spent years reading up on human behaviour. I closely observed my own behaviour and that of many (hundreds of) others around me. I’m no behavioral psychologist but with enough time and focus on this subject, I’m surprised at the depth of knowledge (dare I say, wisdom!) I was able to build up. This does mean that I do not make the classical cognitive mistakes — far from it. In line with late Kahneman’s assertion, this knowledge helps me recognize at least a few of my own cognitive gotchas and on few of those occasions, hopefully contain or even reverse the impact. If I were to distill all that I learnt on this topic until now, I understand that most, if not all, of our sub-par financial decisions can be put under one of the following four categories:
- Our cognitive wiring
- Our moods and energy levels while making decisions
- How we perceive our circumstances while making decisions
- World around us dances to its own tunes
Our Cognitive Wiring
We humans are, originally and essentially, animals. We separate ourselves from the rest of the animal kingdom by our ability to consciously think about things. We have a relatively new, unique and highly developed portion of the brain called prefrontal cortex (disclaimer: I am not an expert on brain anatomy either!) that allows us the ability to think, plan and strategize. However, we do share our primitive portion of the brain with many animals — this portion is called the limbic system and is referred to as “lizard brain” as well. Anatomical details are irrelevant in our context here. Key point to note is that our behaviour is dominated by the “lizard brain” portion of our brain — the unconscious portion of our brain, what Late Daniel Kahneman referred to as System 1. The conscious portion (System 2) plays a decidedly subordinate role to the unconscious portion (system 1). Wealth creation requires us to overcome many of our highly evolved cognitive heuristics of our unconscious brain, which served very crucial purposes during our evolution in the “natural” world but are not always apt in today’s “human” world. Our default cognitive heuristics comprise subroutines, functions and programs that our brain possesses out of box.
“We’re blind to our blindness. We have very little idea of how little we know. We’re not designed to know how little we know.” — Daniel Kahneman
These heuristics have become quite popular as cognitive biases in the last couple of decades. A number of psychologists and economists have discovered these biases. There are many popular non-fiction books and various textbooks on this topic. Given this plethora of material, I do not want, neither do I claim to be able to do any justice, to cover all such biases in this blog, However, I will cover a few impactful ones here.
Innumeracy
“Innumerate people characteristically have a strong tendency to personalize — to be misled by their own experiences, or by the media’s focus on individuals and drama.” — John Allen Paulos
The city I live in (Hyderabad, India) has hardly ever seen a fall in real estate values. Most people would rather wait until the price is at least a little more than their buying price than sell at a value lesser than the buying price. In other words, time correction is acceptable but not price correction. But in reality, time correction typically is also loss in value; Inflation is often ignored or underestimated by most; 7% inflation means expenses double every ten years even without any lifestyle creep; 1000-point increase or decrease in stock market index means much smaller swing proportionally in the index today than ten or twenty years in the past.
Base Rate Neglect
Investing in apartments tend to give low returns, many times even lesser than inflation rate; Most restaurants fail — 90% within 5 years; Despite the fanciful statements such as Bill Gates was a college drop-out, the fact is that on an average, educated folks end up doing well professionally; If a new stock fund is promising a 25% return, you should be wary despite the lure of new, perhaps sophisticated methodology of their stock selection because stock funds on an average return say 12% or something like that.
Sunk Cost Fallacy
“The sunk-cost fallacy keeps people for too long in poor jobs, unhappy marriages, and unpromising research projects.” — Daniel Kahneman
This refers to the tendency of holding on to bad investments at least until you recover your original buying price, resulting in significant opportunity costs.
Loss Aversion
“A person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise.” — Daniel Kahneman
Avoiding equity instruments — particularly the ones related to stock market due to their inherent volatile nature and instead investing in more steady products such as fixed deposits or such; This is important because wealth can only be created by getting a return higher than inflation and bond funds barely beat inflation, if that.
Anchoring Effect
“A key finding of anchoring research is that anchors that are obviously random can be just as effective as potentially informative anchors.” — Daniel Kahneman
I used to run this hastily designed experiment (I came up with it in an elevator flight of six floors) at work. I would ask the participant if he or she thinks Martin Luther King and Gandhi were older than or younger than 60 when they died. Once I receive their answers, I would ask for their guesses on how long they lived. Inevitably, the number 60 would have anchored their answer. Our expectations are anchored to either random numbers or more dangerously, deliberately targeted benchmarks. For example, many financial products are sold with a suggestion of 15% or 18% or some other high return benchmark. Despite disclaimer that this suggestion is just for illustration purposes only, the marketers essentially anchor you to a high expectation.
Mental Accounting
“Almost any bunkum has some partial validity, and we regularly read into the confusing mess what we want to see.” — John Allen Paulos
Mental accounting results in tendency to ignore objective evaluation of money. e.g., Spending more when using credit card than when using cash; Stretching to buy a three-bedroom apartment when your original (already slightly stretched) budget was for a two-bedroom apartment.
Many others
A number of other biases such as Confirmation Bias, Representative bias, Availability Bias, Cognitive dissonance (Rationalization for internal consistency), Tunnel Vision, Status Quo Bias, Endowment Bias, Regret Aversion etc come into play and may compel us into making sub-par or even bad financial decisions, eventually leading to significantly denting your wealth creation journey. It is important to remember that our mental heuristics continue to be very useful in life — so, the idea is not to eliminate them, not that eliminating them is even possible, but to train ourselves to recognize them in our decisions and contain them if they are resulting from bias. A small improvement on this front can lead to disproportionately large gains.
(……to be continued)
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