iCubed
Sunday Times 15 March 2015
Charles Darwin married his cousin, Emma Wedgwood, in January 1839 — but not before giving it some serious thought. In fact, on the back of a letter from a friend he carefully compiled a list of pros and cons regarding marriage and its potential impact on his work.
A wife, Darwin ruminated, would provide “children, companionship, the charms of music and female chitchat”. She would be “an object to be beloved and played with”, although conceding that a wife was in this respect only “better than a dog anyhow”. In his cons column Darwin noted the prospect of “being forced to visit relatives, and to bend in every trifle”; “The loss of freedom to go where one liked, the conversation of clever men at clubs.”
I suspect most people would find this moral or prudential algebra as Benjamin Franklin referred to it, as distasteful at best. We are on dangerous ground here. Setting out pros and cons, attaching weights to each consideration and arriving at a balanced judgment, is pretty callous in relation to matters of the heart. But can we draw any useful lessons from Darwin in relation to more mundane matters, like investing perhaps?
I think we can. But it will take some convincing to persuade you, the reader.
Daniel Kahneman, author of “Thinking fast and slow”, is a renowned psychologist and winner of the Nobel prize in Economics. He refers to our brain as having two systems for thinking. "System 1" is fast, instinctive and emotional; "System 2" is slower, more deliberate, and logical (as demonstrated by Darwin’s process for marriage assessment).
One of Kahneman’s favourite examples of System 1 thinking is what happens when you hear an upper-class British voice say, "I have large tattoos all down my back."
“People who speak with an upper-class British accent don't have large tattoos down their back," Kahneman says. "So the brain brings to bear all the world knowledge that's involved, and registers that there is an incongruity here within three- or four-tenths of a second."
It's the same response you'd get if you heard a male voice say, "I think I am pregnant."
System 2, on the other hand, has to do with orderly computations, rules and reasoning. So if you're asked to multiply 24 by 17 in your head, that's when System 2 takes over.
The automatic system of decision-making evolved because it helped people make rapid decisions in situations where survival was at stake. For example, those whose ancestors had a propensity to see saber-toothed tigers everywhere—even where there were none—tended to live long enough to pass that genetic inheritance down to future generations. The false positive (seeing the tiger that was not there) was far less harmful than the false negative (not seeing the tiger that was). This gave rise to a propensity to overweight negative information that had survival value.
This mechanism in the brain that evolved to provide an ongoing assessment of threat level, has not been turned off, but its value on Wall Street today is far less than on the Savannahs. What might have saved our ancestors from becoming lunch, has bestowed upon us a similar fate only at the hands of greedy capitalists.
The automatic system of thinking is fast because it uses shortcuts (heuristics), which in turn give rise to biases, including Anchoring, Loss aversion and Overconfidence to name but a few. This missive is too short to discuss each of these, but anchoring is a fascinating bias which wreaks havoc with amongst other things, our thinking in relation to finance.
In multiple experiments, Kahneman has found that asking the question “Is the average price of a German car more or less than €100,000?”, produces a far higher estimate of the average price, than where people are asked “Is the average price of a German car more or less than €15,000?”. People will anchor to the number whether it is outrageous or not and will make a guess that is tethered to this number. We think we're smart; we're confident we won't be unconsciously swayed by such an obvious ‘trick’. But we're wrong. The suit salesman that shows you a €1,000 suit even though you are only looking to spend €200 has you anchored, so that €300 doesn’t seem a great stretch. Equally, you may think the high list price of a house won’t influence your bid. You’re wrong.
Some have suggested that cognitive biases might be harnessed in ways that “nudge” individuals in the direction of better decision-making.
A compelling example of the power of the nudge can be found in an examination of the respective organ donation rates of Germany and Austria. According to the European Social Survey, these two countries are extremely similar from a social and cultural perspective. However, the organ donation rate in Germany is only 12 percent compared to an Austrian donor rate of 99 percent.
The explanation for this difference can be found in the structure of the choices on offer in each country. Electing to be an organ donor in Austria requires individuals to opt out, while Germany requires donors to opt in. Default options and inertia are incredibly powerful forces when it comes to making and acting on decisions. This is an example of one of the findings from behavioural finance.
So what are the practical take-aways from this for the investor?
The “nudge” I am going to suggest here is that you get good objective advice and that you commit to a plan crafted during a period of calm. A sort of “Ulysees contract”, that binds you to a course of action in the future and saves you from yourself. During the Trojan wars, the Sirenusian islands were famous for being home to the Sirens, whose songs were so irresistibly seductive that seamen felt impelled to fling themselves into the waters.
Ulysees instructed his crew to fill their ears with wax and then tie him securely to the mast and to ignore his pleas to be released. Ulysses heard the Sirens’ songs, the crewmen ignored his entreaties to be untied. Ulysses had committed himself to a rational course of action at a neutral time. Another example of the reflective mind.
A modern day take on the Ulysees contract would be to draft up an investment plan, called a policy statement. Investment policies are meant to be an enduring guide in an ever-changing external environment. They should normally only change for structural or fundamental reasons, not due to ephemeral changes in the environment such as recessions or financial market fluctuations. Changes in regulations, best practice, or your goals or values might all require an update to a policy. They give an investor a greater sense of confidence and control in the face of an ever-changing and sometimes frightening economic and financial landscape.
In summary, think large – don’t obsess over the specifics of a portfolio; Think long term - commit to an approach; and think smart - be analytical in your thinking, emotions are your enemy .
Slow and meticulous thinking pays off, even sometimes in matters of the heart. Afterall, Darwin and Emma Wedgwood had ten children and remained happily married for 43 years until his death in 1882.
Gary Connolly is Managing Director of iCubed, an investment training, research and consulting company providing investment support to financial advisers and chairman of the valueinstitiute.org. He can be contacted at gary@icubed.ie.