Homo Sapiens has not yet adapted to respond to all today's threats. Here is a random scatter of things that lead us astray.
All these biological biases have been the subject of much research over the years. Which does not mean they are true, of course.....
- We find it emotionally easier to accept a proposal than reject it. That's why we tend to believe the media and salesmen. Even of snake oil.
- We find it easier to follow the crowd.
- Discussions within closed groups (such as the regular lunch group at the office) can be self-reinforcing. They can lead to agreement on propositions that are likely to be false.
- When viewing two independent events, we tend to assume causality. The Aztecs required human sacrifice to prevent the sky from falling on the earth. Hey, it had worked so far!
- We have probability blindness. We are 90% likely to go on holiday and 10% likely to cancel through family illness. We cannot imagine the composite event which is 90% of one and 10% of the other.
- We tend to ignore the small probability of large losses. In real life this is a virtue - otherwise we would never go outside for fear of death by lightning. In investment, the consequence may be precipice bonds.
- We give too much weight to recent evidence and not enough to the distant past.
- We easily confuse conditional and unconditional probabilities. See the Sally Clark cot-death case, 20 years ago but still numbs the mind. The chance of Sally Clark, a young solicitor, having two children die natural cot-deaths was quoted by an 'expert' as 73 million to 1 and the judge allowed the jury to interpret this as the odds of her being innocent. This was wrong because: a) one cot-death indicates a pre-dispostion towards that condition, so the probability of the second death goes up: odds come down to maybe a million to one; b) the correct odds for prosecution are not the odds of specifically Sally Clark having two cot-deaths but the odds of this happening to anyone in the UK. Put another way: every year one mother in the UK suffers a second cot death, by the terrible laws of chance. Are they therefore to be prosecuted for double murder? Having lost both her children Sally Clark went to prison for 3 years and died four years after release from acute alcohol poisoning.
- We are more likely to take risks to reverse a loss than to increase a profit. This is illogical - losses should make us less able to risk further losses.
- We don't like to face disappointment. That is why people like stop-losses. A better name would be 'hide-losses'.
Understanding these biases is important because:
- they can accidentally lead you astray
- they can be incorporated into investment products to intentionally lead you astray.