10 Investing Biases, Fallacies, & Heuristics - Part 1
Fallacies, Biases, & Heuristics That'll Have You Staying Poor
Fallacies, Biases, & Heuristics are all cognitive barriers to your success.
Your brain is an amazing organ that allows you such a range of complex thoughts, emotions, and actions. You have vast unlocked potential. Even people who spend their lives trying to access the depths of their inherent mental abilities, likely only discover a fraction of what is avaiable. It is truly mind-boggling…
Your brain is also lazy & dumb AF.
Like an idiot-savant, your brain will do absolutely [redacted] things in order to cut corners despite having all that untapped potential.
It makes sense though. You are exposed to so much simulation every second of the day and have so much to process, your brain needs to cut out the noise and find the signal.
This leads to your brain taking lots of shortcuts.
And a lot of these shortcuts end up having a negative impact on you achieving your goals.
Biases, Heuristics, and Fallacies, Oh My
These are 3 different terms, however I tend to use them interchangably despite them meaning slightly different things. So before getting into some common cognitive inconsistencies, let’s define each of these. Then I can proceed to ignore the differences and use each term whenever I feel like it:
Fallacy - Incorrect Reasoning
A fallacy is:
Reasoning that is logically incorrect
A false notion
A statement or an argument based on a false or invalid inference.
Incorrectness of reasoning or belief; erroneousness.
When you use logical fallacies, you are using a flawed thought process to get to an incorrect conclusion. Fallacies are always incorrect.
Heuristic - A Mental Shortcut
Heuristics are:
Rules-of-thumbs
Practical shortcuts in thinking that is not guaranteed to be optimal or rational, but may be sufficient for quick decision making
Simplified rules that allow for less cognitive drain
When you use cognitive heuristics, you are taking a short-cut in your thought process to save time or energy. This doesn’t mean your wrong, but many time your short-cut is suboptimal and other times it can be incorrect.
Biases - Internal Preferences & Defaults
A Bias is:
An internal preference to one decision over another
An inherent default choice or way of thinking
A worldview that you don’t update as new contrary evidence comes in
When you have cognitive biases, it is a predictable internal way of thought or behavior. Biases may not be wrong, but they set you up to be manipulated or to make the same mistake over and over.
[Note - Bias is kind of a loaded term in society today. This is solely around your investing and personal finance decisions, and none of the prejudice/racial undertones if used in other contexts]
Difference & Similarities in Bias, Heuristics, & Fallacies
The terms are all related, but with a nuanced difference.
A fallacy is always wrong thinking. A heuristic & a bias are not neccessarily incorrect.
Rules of thumb are there because many times they work
Similarly, you may have a bias for one investment over another - it doesn’t make it wrong. But it opens you to making the same mistakes over as it is a potential blindspot.
Some examples:
Social proof is a heuristic.
You rely on the reviews of others to make a purchase decision as a shortcut to deep time intensive research.
Medium Cups take advantage of your biases through anchoring
When stores have a medium sized cup, it is usually priced more than halfway between the small and large prices. It takes advantage of your bias for a ‘deal’. So you see that going from a medium to a large is ‘only $0.50 more' for 4 ozs, whereas going from a small to a medium is $1 more for 4 ozs. They are using anchoring and getting you to buy the larger size
A logical fallacy is eating past being full to not waste food & money
You already paid for the food, it is a sunk cost. Eating past the point where you are full is unhealthy and a net negative. However, your faulty line of thinking leads to you making a poor future decision.
Anyway, lots of description above, and I will largely use the 3 words interchangably.
I) Naive Diversification
Naive diversification is a choice heuristic where people basically do a poor job diversifying when given options.
It was first shown in the choices of consumers and snacks. If told they had to pick the next 3 weeks of snacks right now out of 6 potential options, consumers would choose a diverse selection of snacks. IE- choose 3-4 of each option. However, if each day the consumer got to pick the snack to eat that day, they diversified less over the 3 weeks. IE- would choose their favorite snack almost ever day for 3 weeks.
This was later replicated with children in a study based on Halloween. If they had to choose all their candy at once, they would wind up with a more diverse bag than if they went to each house one after another. When going house to house, they would wind up with more of their favorite choices.
Just like a child with Halloween candy, investors also do a poor job diversifying. Some examples of naive diversification:
When given ‘n’ choices in your retirement account, you allocate 1/n% to each
ie - given 5 choices and allocate 20% to all 5
When given 5 funds, if 4 of the funds were equity and 1 fixed income, investors would allocate more to equity, however, if 4 were fixed income and 1 was equity, investors would allocate more to fixed income.
ie-if given 4 equity funds you invest 80% in equity, but if given 4 fixed income funds you invest 50% in equity.
Investing across ETFs without looking at the holdings and assuming more diversification than you are getting
These are ranked on a scale of most naive to less naive.
Doing 1/n% allocation to all n options you are given is not even trying to make a distinction. When I started working and my mother asked me about her 401k and I looked at it, this is what she was doing. Her plan had about 20 funds in it. The majority of which were redundant - ie an SP500 index low fee ETF but also 3 different SP500 mutual funds with higher fees.
You basically threw your hands up and said you don’t understand any of it, cried at your desk for 35 mins (hi mom) and then just put the same number in each option with no plan.
The 2nd example above is letting your allocation be influenced by the options given. This implies you had some target allocation, but then naively adjusted it. Lets say you wanted to do the hypothetical 60/40 equity to bond allocation. But your 401k has 4 bond funds and 1 equity fund. You put 10% in each bond fund and 60% in your single equity ETF. (Leftmost pie chart below)
Then you look.
“60% in one option seems not diversified,” you think. So you adjust your allocation to something different because of that big 60% slice of your allocation pie chart staring at you. That is naive diversification.
Your equity ETF has likely 100 of names. You are seeing your allocation like the pie chart on the left with 60% in one ETF and getting nervous. But that Equity ETF is much more like the chart on the right.
What makes it naive, is if you buy more bond ETF just to make your equity ETF slice look more equal.
[Note - I used 60/40 as its the portfolio most people think of as ‘balanced’. I actually think it is a terrible allocation for most people. At a minimum, if your younger (10+ yrs out of retirement) more equity will probably serve you better]
Most Common Form of Naive Diversification
The above 2 examples of naive diversification are traps for the less sophisticated. However, the most common form of this fallacy I see is the last one.
Let’s say you are a fairly conservative investor who wants to be diversified and stay in larger cap stocks. You set a 5% max allocation to a stock and set up your portfolio:
35% SP500 ETF
35% QQQ (Nasdaq ETF)
10% World Index ETF
5% to Apple, Microsoft, Amazon and other miscellaneous stocks
Not bad right? Seems like you have a nice mix of ETFs spanning SP, Tech, and the world, plus allocation to some big blue-chip names…
Yup, Apple is 6%, 13%, and 5% of the total indices you purchased. Microsoft is 6%, 10%, and 4%. Amazon is 4%, 6%, and 2%.
So when you look across your entire portfolio you are 12% Apple, 11% Microsoft, and almost 9% Amazon. Whether 10%+ in one name is a good stratey or not isn’t the point. The point is you were thinking you had 5% max exposure to any single name, but you have double that. This is way more exposure than you were planning. Your portfolio is 1/3 allocated across the top 3 choices.
[Note-Also, did you know that the top 3 single-stocks across these 3 very different ETFs were the same? The 3 ETFs you would think would be fairly different. Another reason it may seem correlations are headed towards 1]
People will make this mistake within a portfolio, but more often it is accross portfolios. Maybe your 401k only has ETF so you are 50% QQQ and then in your personal portfolio you have a bunch of redundant individual names that make up the QQQ, like Apple, Microsoft, and Amazon.
This is a great segue to the next fallacy…
II) Mental Accounting Bias
I normally like to paraphrase, but Mental Accounting Fallacy in personal finance was made popular by Rich Thaler form the University of Chicgo Booth School so I’d be hard-pressed to sum it up better than him:
"Mental accounting is the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities."
-Richard Thaler
In short, you suck at keeping track of all your money in your head. Money is fungible (all the same & interchangable) but in your head you don’t treat each dollar as the same and that leads to poor decisions.
[Note- The word fungible is making a big resurgance thanks to NFTs, non-fungible tokens. NFTs mean each token is unique and identifiable. Whereas if you have a pile of $1 bills, each one has the exact same utility as the other, completely replacable]
Mental Accounting Bias shows up in many forms, but tend to coalesce around the underlying issue of making poor opportunity cost decisions because you think of different money different ways.
For example, lets say you have credit card debt at 20% interest. (Bad. Pay it off and never accrue high interest credit card debt. At a minimum, get a 0% loan as I lay out with the Ultimate Debt Cheat Code)
You also want to go on vacation. You are paying down your debt first though, that is your plan. Then you get a surprise $2k check. This windfall money you put in a separate account for your vacation. In your head this bonus is different than your standard pay and so you treat it different than your regular income.
The fallacy you made was treating the $2k bonus as different than your regular pay. Money is fungible, those $2k is no different than any other money you make, so you should have treated it the same and put it toward the high-interest card.
Another form of mental accounting bias is related to naive diversification. For example, you have 2 accounts and look at them separately instead of looking at all your money combined in one aggregate portfolio. So your 401k is your ‘safe diversified’ account where you hold mostly QQQ & SP500 ETFs.
Then you have a 2nd separate brokerage that you invest mostly in big single names like Apple, Amazon, and Microsoft. Each portfolio may be diversified on its own. And in your head you have a ‘safe’ portfolio of ETFs that is adding even more diversification from the ‘riskier’ portfolio of single names.
But as shown above in naive diversification, you basically have a huge allocation to Apple, Amazon, and Microsoft. Looking at your portfolio in aggregate and at holdings you would see that.
Is Mental Accounting Bias Always Bad?
Mental accounting is not always a bad guy. Especially not if you are aware of it.
Some amount of mentally splitting your money may allow you to save more. For instance, if you can live off of one salary in a 2 salary household. You may have one spouse’s income all go to a savings & investing account. This may allow you to save more than pooling the money in 1 account where you would be tempted to spend it on frivolous things.
That is an example of using mental accounting to your own benefit.
However, mental accounting is bad when you are unaware of it and make subpar decisions.
Wrap-up: 10 Biases, Heuristics, and Fallacies - Part 1
Clearly more posts are coming with biases, heuristics, and fallacies.
Naive diversification and mental accounting go hand-in-hand as they tend to result in similar issues in a portfolio.
You won’t ever be free of biases and heuristics, but the goal is to recognize they exist and try to prevent them from becoming detrimental.
Any chance you could do car buying 101 used vs new vs leased. I live in area where travel is a must so vehicle is of great importance. Being a item that depreciates I figure you can make a great post on something like this. Is Lease actually a good option? How good is new? Those sorts of things but In the F'er way.