A bat and ball cost a pound and ten pennies. The bat costs a pound more than the ball. How much does the ball cost?
The vast majority of people answer 10 pence.
The impulse answer is both obvious and wrong.
The correct answer is in fact £1.05 for the bat, and £0.05 for the ball (answer at the bottom of the page).
For over 50 years, Daniel Kahneman a nobel laureate and professor of psychology at Princeton University has been asking similar questions and analysing our answers. For many years, theoretical models in many academic departments such as psychology, economics and the social sciences, had taken for granted that human beings are essentially rational beings. But Kahneman and others have shown that we are not nearly as rational as we like to believe.
When people face uncertain situations, they don’t go looking for statistical evidence or carefully evaluate the information to hand (as the models predicted). Instead they rely on mental shortcuts such as the one you probably used earlier, and it is these shortcuts which often lead to poor decisions.
According to a study in the Journal of Personality and Social Psychology, in many instances, smarter people are more vulnerable to these thinking errors.
Given that the default shortcut is usually the route that requires minimal mental effort, what should investors do? I would recommend reading Daniel Kahnemans book http://www.amazon.co.uk/Thinking-Fast-Slow-Daniel-Kahneman/dp/0141033576 but don’t expect a miracle cure. Given that many of our mental shortcuts are largely subconscious, many are relatively immune to conscious introspection.
Over time however, you may learn to manage some of the more dangerous mental shortcuts.
b+1=a, or b=a-1 (2)
Substituting (2) into (1) gives:
Substituting a=1.05 into (1) gives:
- Are you above average at your job?
- Are you above average at making love?
- Are you an above average driver?
The vast majority of people answer yes to these three questions, which of course cannot be correct because half must be below average. By answering ‘yes’ you have displayed overoptimism.
The tendency to overrate our abilities is amplified by the illusion of control – we think we have more control over outcomes than we actually do. For example, did you know that people will pay four times more for a lottery ticket if they pick the numbers themselves, versus having a computer randomly pick the numbers for them? The act of picking numbers yourself does not make them any more likely to occur yet most people place a premium on the option.
Optimism seems to be the default state for most of us, but why?
Scientists suggest that optimism presented some kind of evolutionary advantage. Searching far and wide for food, hunting wild animals and other similar activities once performed by our ancestors involved taking risks (see this link for more information). Pessimists would naturally avoid such risks.
Psychologists have documented a ‘self serving bias’ whereby people are prone to act in their own best interests. Try asking a barber if you need a haircut, or a management consultant if you need some consulting, or a personal trainer if you could do with some one to one workouts if you want to see the self serving bias at work.
The self serving bias is particularly dangerous in investing. If you choose to seek the advice of an expert, be very careful as to whom you choose to listen. The recent financial crisis provides plenty of examples. Just before the market crashed, 91% of analysts rated shares as either ‘buy’ or ‘hold’. At the same time, the ratings agencies, who were funded by the loan issuers they were rating, rated many sub investment grade loans as AAA.
So how do we beat this tendency? We must learn to think critically and be more skeptical. Ask why should I buy this property, not how can I buy this property.
Given the ice bucket craze that seems to be going around I thought I would post up a funny property development related challenge (don’t try this at home kids…):
On a more serious note, I looked up the disease amyotrophic lateral sclerosis (ALS), for which the ice bucket challenge is raising awareness (participants and nominated individuals make donations to a charity). Although Stephen Hawking is perhaps the worlds most famous person living with ALS, you may not know that over 500,000 people are living with the disease right now, somewhere in the world.
Imagine that you are one of the most talented graffiti artists in your City. Imagine that you have ALS and you lose all movement in every muscle in your body except your eyes.
How do you continue your passion?
Simple. You paint with your eyes! Check out this video:
Why not take a moment to be grateful for the many advantages that you enjoy?