A 3-question quiz to start …
- Wanda is 31, single, outspoken and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice and participated in anti-nuclear demonstrations. Which is more likely: Wanda is a bank teller or Wanda is a bank teller and active in the feminist movement?
- We’ll flip a coin 100 times. I pay you $2 each time it’s heads, and you pay me $1.75 each time it’s tails. How many flips do you want to bet on?
- Your good friend tells you the estimated deer population in Pennsylvania is about 1.9 million. What’s the correct number?
If you’re like most people, you will have answered at least one question in an irrational way, especially if you encounter it in “everyday life”, not when it’s in a quiz.
The point? We often make irrational decisions. In investing or personal finance, that’s a problem. For example, we are more attracted to stories than to maximing probabilities (q 1). We have an exaggerated fear of loss, leading to lower average returns than what you could achieve without that fear (q 2). We are influenced by “anchors”, or data points with no true importance — for example, we refuse to sell losing stocks until they get back to their purchase price (q 3).
One of my key roles as a financial adviser is preventing clients from making sub-optimal decisions. I have spent considerable time studying behavioral economics because it may be the single biggest determinant of investing success.
And by the way, the answers are: a bank teller, 100 times and no one knows … but you probably guessed a higher number than if your friend had estimated 250,000 as the deer population.