We use mental shortcuts (heuristics) to make decisions rapidly. These work in many circumstances, but when it comes to investing, they can be a major handicap, giving rise to “cognitive biases”. Key examples include the following:
Anchoring: the tendency to “anchor” to a piece of data we are exposed to while making a decision, regardless of pertinence. For example, in a 1974 study, Kahneman and Tversky asked subjects to write down the last three digits of their phone numbers, multiplied by 1,000. They were then asked to make estimates of house prices. The higher the phone number, the higher the estimate. In investing, anchoring can, for example, tempt you to buy a stock that has fallen after a profit warning, because you have ‘‘anchored’’ to its previous price and see it as a bargain, disregarding the deterioration in its fundamentals.
Framing: this refers to the fact that people often draw different conclusions from the same underlying information, depending on how it is presented, or “framed” (which is entirely at odds with the “rational actor” theory of efficient markets). Again, this was formalised by Kahneman and Tversky in a 1979 research paper on “prospect theory”, which tries to model how people make decisions involving probability in the “real world” as opposed to the idealised economic world.
Loss aversion: the pair also found that individuals suffer from “loss aversion” – we feel the pain of losses roughly twice as acutely as we enjoy the pleasure from gains, which goes some way to explaining why “framing” information on decisions in terms of risks rather than rewards can alter our reported preferences, even if the underlying data is the same.