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Intentional or Intuitive? What drives your investment decisions?

Anyone who has read the basics of investing knows that the secret is to buy low & then sell high. Sounds simple enough right, but over and over again we do the exact opposite.  Why? There are plenty of investing scams. When we read about them in the news we are surprised that people can’t see through such obvious scams, but throughout our lives we fall for different scams ourselves? Why?

In the image below there are two bowls. You are shown the contents of the bowls initially and then both bowls are shielded from view. You can no longer see the balls inside. Your aim is to pick a red ball. You can choose to draw from ONE of these bowls. Which bowl will you choose?

Which bowl would you choose from?

 

This experiment was conducted at MIT and most people who participated chose to pick a ball from the bowl containing a hundred balls.  Even though the participants logically knew that they were more likely to pick a red ball from the 10 ball bowl (probability of picking a red ball = 10%), they still preferred to try their luck in the 100 ball bowl (probability of picking a red ball = 5-9%) just because they can see a lot of red balls in that bowl.

Let’s take another very commonly seen optical illusion.

optical illusion investing

 

Which line is longer? If you have already seen this illusion somewhere else you know the answer. The two lines are equal in length but even after seeing the proof, it is hard to convince ourselves of this.

Why? Because we have two brains.

Man with two brains

We have a reflexive brain and a reflective brain. The reflexive brain acts as a gatekeeper while the reflective brain thinks. Some people use one more than the other, but we all have and use both. When you are driving, your reflexive brain is the one that alerts you and makes you hit that brakes when there is an obstacle in your path. When you are doing a calculation, the reflective brain kicks in.

Simply put, your reflexive brain feels, while your reflective brain thinks.

 

Most of us, when investing, use our reflexive brain excessively when it should be the reflective brain that is doing the heavy lifting. For example, let us look at 2 common scenarios where we make bizarre decisions.

  • Gold prices are going up. You decide it is the right time to buy, because gold is doing so well!
  • The stock market is heading downhill. You panick, decide to sell everything and stay away for a while, with the intention of getting back in when the market bounces back.

You acted on visual cues, pretty charts, emotions and adrenaline. If you had let your reflective brain in on the action, it would have cautioned you about the discrepancies in the data.

Does that mean you should always use your reflective brain when making financial decisions? No. The reason is simple – you can never have all the information for the reflective brain to make the perfect decision. There is always that one piece of data that makes a difference and people using the reflective brain alone can’t see the forest for the trees, which would again cause them to miss many opportunities.

Investing Basics : What is the best way to invest?

You have to use both your reflective and reflexive brain at the right time and with the right balance. It might sound impossible, especially with the double headed irrational monster we are talking about. But we can trick the brain into making rational decisions. The secret is to have a plan and to know yourself.

To balance the reflexive brain

    • Create some passive barriers (go for a walk before you buy, take a cold shower to overcome the emotion)
    • Always ask a second question. I got this neat little idea from the book “Your money & your brain“. For example, you see a chart like the one below. You see that the company is performing well and the stock price is on an up slope, so you want to buy the stock. First, ask why. You might come back with – well it is a growing stock. Ask a second follow up question – how do you know it will continue to grow? Now do you see the problem with the answer to your first question? You answered the question “what is happening to the stock now” you don’t have enough data to answer the question what will happen to the stock in the future. For that you have to use your reflective brain.

Chart Company A

  • Instead of proving how an investment is a good purchase, try to disprove it. This is a good exercise to expose the holes that you might have overlooked when trying to convince yourself to buy.
  • Have a partner/friend who does not have the same emotional habits as you and run your decision by him/her.

To balance the reflective brain

  • Accept that you do not know everything.
  • If something is too good to be true, it probably is.
  • Even if the numbers look right but something doesn’t feel right, don’t be in a haste to make a decision.

To put these into practice, have a checklist of things you have to go through every time you make a decision. A series of questions about you, the market, the company and the fund will help you trick your brain into making a good decision for you.


{ 20 comments… read them below or add one }

Hunter @ Financially Consumed

This an interesting topic. I could see myself as you described reflexive and reflective thinking. Your model seems workable, but I think the key to making this successful is having ready access to your peers in a social network. The Yakezie forum would be a good place to bounce an idea and see what the group consensus is. But, once you have poled the group, I think it’s still a valid decision to against the majority. At least you took the time to challenge your first instincts.

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MoneyCone

Excellent post! I loved the examples! One other folly is to follow the herd! Ask anyone who’s been through the dotcom boom and the subsequent bust!

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Jen @ Master the Art of Saving

Great post, Suba. I’d never really thought about any of this. What does it mean if you think reflexively but it’s opposite of what others would do reflexively? For example, if I saw lots of stock dropping, I’d get excited and want to snatch them up quickly or gold prices are climbing so I want nothing to do with it now—maybe later if it drops really low then I would. It seems like that should be considered reflective but it seems reflexive. Just curious.

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Financial Independence

Very good written, thank you.
What I am curious about, if people would be able to select growth stocks so easy, they could do it professionally. but I guess the same logic would apply to any purchase – real estate, or mutual fund…

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Untemplater

I stopped investing in single stocks and switched to ETFs bc I always panicked and sold at the worst times. With ETFs I just let them do their thing and focus on the long term. It’s not the best strategy but it has kept me from wanting to sell low! -Sydney

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Aaron Hung

great explanation on the two brains :D I’ve never saw it like that.

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retirebyforty

I like your strategy of having a check list before we buy stocks. I’ll need to put one together. I’m leaning more toward dividend and ETF investing these days so I can minimize the panic selling.

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Jeffrey Trull

“Instead of proving how an investment is a good purchase, try to disprove it.” I really like this advice because we ALWAYS want to convince ourselves of the upside of things and ignore the potential downside. I know that this is for investing, but this is really great for just about any financial decision.

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funancials

Great article Suba. I would still choose the bowl with 100 balls, knowing the probability. If you’re confident in your memory and hone in on where 2 red balls are close together, you should be able to stick your hand in a 10 ball circle. If you miss on the one red ball you may hit the other. I’m thinking I could narrow down the 10% odds to 20%.

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Krishanu

This is exactly the phenomenon being talked about in this post. Even MITicians are ‘fooled’. The thing is the balls are NOT remaining in their same places, they are moving around (balls in a glass bowl WILL move). So your I-can-rely-on-my-memory theory is a ‘trick’ being played by your reflexive brain to pull one over the reflective one.

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Tushar@EverythingFinance

I never knew the 2 brains thing…Reflexive and Reflective!
Very Interesting.

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Krishanu

Absolutely bang on! Great examples.

Though the neural science behind the irrational decisions I’ve seen taken by people were not really this explicitly known to me, I think I kind of knew. Time and time again -> mad rush to sell when stock market is going down.

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Invest It Wisely

Interesting post! The funny thing is the first thing I looked at is the probability, but of course we’re assuming perfectly random distribution? If you know all the red balls are in a single bunch then maybe you go for the one with more red balls even if the random odds are slightly lower.

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20's Finances

Great post with lots of information. Does it say anything that I would have chosen the bowl with only 10 balls? (and I’m not just saying that). I wasn’t thinking about statistics so to speak, but I was instead thinking, ‘Oh, there are only nine balls that I could pick that aren’t red.’

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Miss T @ Prairie Eco-Thrifter

Very interesting topic. I really like the graphics too. I would say I am a mix between the too but tend to lean more towards the reflexive side which sometimes hurts me. I am working on trying to be more reflective in general which should help numerous things, including my finances.

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First Gen American

I also love your line to try to disprove that something is a good buy.

I hate trying to time the market so if I want to buy I say, “I want the market to drop to X before I buy.”
Maybe this is a flawed approach but “the market” makes even the best stock picks fluctuate up and down independently of how a company may be performing otherwise.

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101 Centavos

I too like the idea of disproving a good deal. A saying I’ve heard often at work is, “don’t want a good deal so bad you make it into a bad deal”, meaning you’ll eventually concede more than you had intended. In following our heart and emotions, I suppose we’ll eventually be guilty of confirmation bias, seeking the right type of information that will validate our decisions.

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Everyday Tips

I used to try and time the market, but not anymore. I pretty much invest in index funds, although I do have a few dividend stocks that I invest in. (Using dollar cost averaging though.)

I am getting a little disheartened with investing lately. I think I am going to build up a little more cash.

By the way, I picked the bowl with 100 balls.

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Money Reasons

Wow, this is a great article! Loved it!

I like to think that I’m logical thinking, but I think I would have tried to pick the red ball from the 100 balls too.

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Andrea

Great post I am going to come back and reread when I have more time!

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