Human beings are the ultimate product of evolution. It has produced great minds like Issac Newton, Albert Einstein, and Thomas Edison.
Gravity was discovered by Newton. This discovery explained why earth revolves around the sun and moon revolves around the earth. It was the same Newton who lost his money in south sea bubble. He wrote – I can calculate the movement of stars, but not the madness of men. How do we explain this? Almost everyone was trading the stock and getting rich. Newton fell for social proof and envy; two powerful psychological biases.
Einstein’s theory of relativity was a stroke of genius. It is undoubtedly the highest intellectual achievement of humanity. At that time all scientists including Einstein believed that the universe was static. But his equations and models revealed that the universe is expanding. What did Einstein do? He introduced a fudge factor called as cosmological constant to the equation to stay consistent with the static universe. Once Einstein knew that the universe was expanding, he discarded the cosmological constant as an unnecessary fudge factor. He later called it the “biggest blunder of his life“. Why did he do it? Einstein fell for commitment and consistency; one of the strongest psychological biases.
Thomas Edison was an inventor who had more than 2300+ patents. One of his inventions was Direct Current (DC). Nikola Tesla was a Serbian-American inventor who worked for Edison. He developed Alternating Current (AC) under Edison’s supervision. AC was superior to DC in several ways. What did Edison do after the discovery? Watch the video to find out what he did. Edison fell for liking; one of the strongest psychological biases.
If some of the greatest minds fell for psychological biases then where are we?
There are few things that we can do to reduce our irrationality (1) To acknowledge the we are irrational (2) To learn about them by reading Charlie Munger’s psychology of human misjudgment. (3) Use them everyday.
Using them everyday is the hardest step. I was struggling on this part for a long time until I came across an interview with Michael Mauboussin. The solution is simple. Carry a notebook and keep track of all your decisions. This was the advice that he received from psychologist Daniel Kahneman. Excerpt from the interview.
When I pose him the question, what is a single thing an investor can do to improve his or her performance, he said almost without hesitation, go down to a local drugstore and buy a very cheap notebook and start keeping track of your decisions. And the specific idea is whenever you’re making a consequential decision, something going in or out of the portfolio, just take a moment to think, write down what you expect to happen, why you expect it to happen and then actually, and this is optional, but probably a great idea, is write down how you feel about the situation, both physically and even emotionally. Just, how do you feel? I feel tired. I feel good, or this stock is really draining me. Whatever you think.
The key to doing this is that it prevents something called hindsight bias, which is no matter what happens in the world. We tend to look back on our decision-making process, and we tilt it in a way that looks more favorable to us, right? So we have a bias to explain what has happened.
When you’ve got a decision-making journal, it gives you accurate and honest feedback of what you were thinking at that time. And so there can be situations, by the way, you buy a stock and it goes up, but it goes up for reasons very different than what you thought was going to happen. And having that feedback in a way to almost check yourself periodically is extremely valuable. So that’s, I think, a very inexpensive; it’s actually not super time consuming, but a very, very valuable way of giving yourself essential feedback because our minds won’t do it normally.
For the last six months I am keeping track of all my decisions, thoughts, and everything in a diary. This is helping me a lot in learning about myself. I receive a lot of valuable feedback from the diary and I use it to correct my biases. Also it helps me to avoid getting influenced from the surroundings. Some of the interesting things that I learnt from the diary are given below.
After selling a stock
After selling a stock, I check its price everyday for several weeks. I feel happy when the stock price goes down after the sale. I feel sad when when the stock price goes up after the sale. The stock does not care nor it has any memory of my selling price. Why do I behave this way? Human brain wants to be correct all the times and it likes winning and hates losing. This bias is loss aversion.
Stock market crashes in May
In the month of April, I was discussing about stocks with some of my friends. One of them told that the US stock market will crash in May. Not sure how he knew it. But I promptly noted this statement in the diary. In the month of June I verified if this fact was true. S & P 500 index on May 1st opened at 1884.39 and on May 30th it closed at 1923.57. Clearly the market did not crash and in fact it went up by 2.07%.
I am sure that someone will make the same statement next year and it will come true in one of the years. If that happens the person who told this will boast about his predictive powers. What is the fallacy in this? Our brain will only keep track of predictions that came out as true and ignores all the ones that came out as false. We focus on the numerator and ignore the denominator. This is availability bias.
Few of my friends invested in esoteric assets. I want to understand the rational behind their purchase.
Me - What is the base rate of success in this? Friend - I do not know. Me - Then why did you buy? Friend - Because X and Y bought and hence I bought. Me - Why do you think X and Y are correct? Friend - Because X and Y are smart. Me - X and Y are smart in esoteric investments? Friend - No they are smart software engineers. Me - Stunned.
I spent $5 on the diary and I consider it as one of the best value investment I have ever made.