2725: Cognitive Bias by The Mad Fientist on Financial Investments & Investing Risk vs. Reward

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[00:00:40] This is Optimal Finance Daily, episode 2725. Cognitive Bias by the mad scientist of

[00:00:47] madfientist.com. And I'm your host and personal finance enthusiast, Diana Merriam.

[00:00:53] This is the show where I serenade you with the sweet sounds of personal finance knowledge

[00:00:57] from some of the best blogs on the planet, with the author's permission, of course.

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[00:01:26] Cognitive Bias by the mad scientist of madfientist.com.

[00:01:32] Let's all step into the mad scientist laboratory for a minute to run a little experiment. I'm

[00:01:38] going to give you a couple of scenarios and you just have to quickly choose one option and then

[00:01:42] move on to the next scenario. Imagine you're the head of the US Center for Disease Control

[00:01:48] and a deadly disease breaks out. There's been an outbreak on two separate islands and there are

[00:01:54] two courses of action you can take on each island that will affect how many people survive the

[00:01:59] outbreak. Island number one. On island number one, if program A is adopted, 270 people will die.

[00:02:08] If program B is adopted, there's a 40% chance that no one will die and a 60% chance that all

[00:02:15] 450 people on the island will die. Island number two. Programs A and B can't be implemented on

[00:02:24] island number two. So you have to instead choose between program C and D. If program C is adopted,

[00:02:31] 180 people will be saved. If program D is adopted, there's a two in five chance that

[00:02:38] all 450 people on the island will be saved and a three in five chance that nobody will be saved.

[00:02:45] Selections. Did you choose programs B and C? When this experiment is conducted in an actual

[00:02:52] laboratory, the vast majority of people chose program B over program A and program C over

[00:02:58] program D. So what's the point? Let's take a closer look at these scenarios again. The expected

[00:03:05] values of the programs are actually exactly the same for all four programs. For program A,

[00:03:11] 180 out of 450 people will be saved. For program B, the expected value is 180 saved.

[00:03:19] Now if you also take a closer look and compare the two scenarios, you'll see that program C and D

[00:03:25] are exactly the same as programs A and B respectively. For program A, 270 people will die,

[00:03:32] so 180 people will survive, which is the same as program C. For program B, there's a two in five

[00:03:39] chance that everyone will survive and a three in five chance everyone will die, just as in program

[00:03:44] D. So all programs are equal in terms of effectiveness. Programs A and C are exactly

[00:03:51] the same and programs B and D are exactly the same. So why is it most people choose to gamble

[00:03:58] in the first scenario, program B, but choose the sure thing in the second scenario, program C?

[00:04:04] It's all about how the outcomes are framed and how we feel about risk and loss.

[00:04:10] Framing, loss aversion, and risk. If the problem is framed as a loss, as it is in the island number

[00:04:17] one scenario, focusing on the people who will die rather than the people who live,

[00:04:22] we become risk seeking. Since 270 people will definitely die if we choose program A,

[00:04:28] we'd rather risk killing everyone for the chance of saving those 270 people.

[00:04:33] If the program is framed as a gain, however, as it is in the island number two scenario,

[00:04:39] focusing on the people that will be saved, we become risk adverse. We want to protect our gains,

[00:04:45] in this case, the saving of 180 people. So the majority of us would choose program C

[00:04:51] to avoid the risk of losing those 180 if we instead chose program D.

[00:04:56] So simply by framing the same exact outcomes in different ways, we've altered the decisions

[00:05:02] of the majority of the population. How does this apply to finances?

[00:05:07] So why am I making you put islanders' lives at risk? To illustrate that your brain often

[00:05:13] affects your decision making without you consciously being aware of it. You may feel

[00:05:17] that you're smarter than other people and that you're able to make logical decisions when it

[00:05:21] comes to your finances, but these subtle quirks of your mind influence every decision you make.

[00:05:28] Anchoring. Let me present to you another study to further reinforce this point.

[00:05:33] We've all probably heard of Gandhi. If you close your eyes, you can maybe even picture him.

[00:05:38] Since the image is likely an image of him shortly before his death,

[00:05:42] you'd most likely do reasonably well guessing how old he was when he died.

[00:05:47] If before asking you how old you think Gandhi was when he died, I ask, did Gandhi live to be 140?

[00:05:55] You'd probably laugh at my stupidity and say, no, that's ridiculous.

[00:05:59] If before asking you how old you think Gandhi was when he died, I ask, did Gandhi live to be nine?

[00:06:05] You'd probably also laugh at my stupidity and say, absolutely.

[00:06:09] Neither of the responses to these two ridiculous questions is surprising.

[00:06:14] What is surprising, however, is how the responses to the how old was Gandhi when he died question

[00:06:20] are affected when you proceed the question with one of the two ridiculous questions just mentioned.

[00:06:26] When asked, did Gandhi live to be 140 before being asked how old he was when he died,

[00:06:31] participants answered on average that he was about 67 when he died.

[00:06:37] When participants were instead asked, did Gandhi live to be nine before being asked how old he was

[00:06:42] when he died, participants answered on average that he was 50 when he died. In this experiment,

[00:06:49] the ridiculous scenarios, even though they were far-fetched, served as anchors that ultimately

[00:06:54] affected the answers to the question about Gandhi's age at death. It's not hard to see

[00:07:00] how this type of anchoring could affect your financial decision-making. If all the talking

[00:07:04] heads on CNBC are saying that Dow's going to go to 18,000 by year's end, an anchor is set in your

[00:07:12] mind that could potentially affect your view of the market and subsequently your interactions with

[00:07:17] the market. Other examples. The bad news doesn't stop at framing and anchoring, however. There's

[00:07:25] also confirmation bias, the idea that we tend to place more weight on opinions that we agree with

[00:07:30] and discount or disregard information that we don't agree with. Illusory superiority,

[00:07:36] about 80% of the population believes they are above average drivers, and many, many more.

[00:07:43] How can you save yourself from yourself? So what's the solution? My advice is to try to

[00:07:50] take your brain out of the investing equation as much as possible. I know that probably sounds

[00:07:55] like the worst investing advice ever, but let me explain. Your brain is useful when setting up an

[00:08:00] investment plan, but it's not useful when you execute that plan, for reasons mentioned already.

[00:08:07] I invest the majority of my portfolio in a total stock market index fund.

[00:08:11] This simple strategy has allowed me to take my brain out of the what question completely

[00:08:16] when it comes time to invest. I don't spend hours agonizing over which stock to invest in this month,

[00:08:22] and therefore, I don't let all of the external factors present in the world unconsciously

[00:08:28] influence my decisions. You can also take your brain out of the when question as well.

[00:08:33] To do so, set up an automated investment plan that automatically invests a certain amount of money

[00:08:39] every month. Automating your investments will further decrease the possibility of your brain

[00:08:44] sabotaging your investment plan, and will allow you to consistently invest your money

[00:08:49] as soon as it's available to invest. You just listened to the post titled

[00:08:58] Cognitive Bias by the Mad Scientist of madscientist.com, and I'll be right back with my

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[00:10:20] the edge it needs with USPS Ground Advantage Shipping from the United States Postal Service.

[00:10:27] Keep everything simple with clear upfront pricing and no unexpected surcharges.

[00:10:33] Keep things affordable with some of the lowest prices out there. And keep it all reliable with

[00:10:39] on-time ground shipments. It's time to turn shipping to your advantage. Learn how at USPS.com

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[00:10:55] This article reminded me of the importance of reframing a situation when you're trying to come

[00:11:00] to a well-thought-out decision. So for example, in the FIRE community, people often obsess over

[00:11:06] their FI number. Is it going to be enough? Did I calculate it correctly? Do I have enough to retire?

[00:11:14] I think a much more helpful question, especially if someone's really young,

[00:11:17] is to ask if you have enough money to take a risk. So much of the future is unknowable.

[00:11:24] And if you're waiting for 100% certainty to make a change, you're probably going to feel

[00:11:29] stuck for a long time. Another question I think is helpful is to ponder what you would do if you

[00:11:35] could never retire. I like this one because it forces you to get creative about what you could

[00:11:40] do to make changes now and to not put your life on hold in pursuit of a financial goal. And when

[00:11:47] it comes to confirmation bias, I also think many financially savvy people have a strong negativity

[00:11:53] bias. We're always asking what could go wrong and how we can plan for it, but we rarely ask what it

[00:11:59] looks like if things go right. That should do it for another edition of Optimal Finance Daily.

[00:12:05] Have a great rest of your day, and I'll see you tomorrow where your optimal life awaits.