Your brain is like Tiger Woods -- impressive in its achievements, seemingly well-suited for its tasks, but nonetheless prone to embarrassing stunts with disconcerting frequency.
It's no wonder: Charged with making sense of the world around us, our brains face an arduous task. Given the sheer torrent of information gushing toward us as if from a fire hose aimed at a teacup, our mind can't help but take shortcuts. And those shortcuts can manifest with particular rancor in our investment decisions.
Five Mental Shortcuts That Will Hose Your Returns
Every time we take in new information about a company -- be it from an article, television program, press release, or elsewhere -- our brains try to scuttle down their well-worn shortcuts. It scrambles to form opinions and make decisions. And all too often, it steers us down the exact wrong path.
In a volatile market all too ready to acvtivate our mental gimmickry, it's more important than ever to be able to recognize the tricks our brains play on us. Before you make a trade, be on the lookout for these five "brain games."
1. Recency bias
When you overweight recent events when drawing conclusions, you are falling prey to recency bias. For example, oil companies have been strongly profitable in the last couple quarters. BP (BP) just turned in a $101 billion quarter, the first time the company has cracked into 12-digit range since 2008. But to conclude that oil companies make great investments would be myopic. Of course profits are high right now -- oil is near $90 a barrel -- but this is a cyclical industry, one in which peaks are eventually and inevitably followed by troughs.
2. Inconsistency avoidance
The inertia of our past decisions can be a powerful force. Quite simply, we don't like to change our minds. This can be positive at times -- for example, an intern labeled as "smart" will strive to the ends of the earth to maintain that reputation (not that we used such mind tricks on our own interns...). But unless we are vigilant, we can also anchor to past decisions that might not have been sound in the first place, or fail to update our thinking in light of new information.
3. Influence from mere association
A hypothetical new manager at Macy's (M) sees this chart of quarterly sales versus the average temperature at company headquarters in Cincinnati, Ohio:
The manager concludes that cold temperatures induce customers to spend more money at Macy's stores. So he drafts a proposal to open new stores only in cold climates.
This is, of course, ridiculous. Macy's sales spike higher in the winter because of holiday shopping -- not because of the temperature. The holidays cause the higher sales; the weather is merely associated with sales. Our overzealous manager is confusing the two. As absurd as the mistake may seem, such investing conclusions are drawn all the time. Don't become a cautionary tale. Focus on what actually drives a business, not the irrelevant associated events.
4. The "loss double-ouch phenomenon"
In these volatile markets, think about your own reactions to 3% down days versus 3% up days. If you are anything like most people, the down days sting viciously, but the up days are only mildly pleasant. Research has shown that we feel losses twice as strongly as we do gains. When you combine this emotional reaction with the human instinct to avoid pain and seek pleasure, a problem becomes evident: If pain is more painful than pleasure is pleasurable, our risk tolerance can be driven to detrimentally low levels.
5. Ambiguity avoidance
People do not like ambiguity. Actually, let me rephrase that: We loathe ambiguity. To counter it, our brains want desparately to reach a conclusion -- often any conclusion -- quickly. This is, in my opinion, the worst of the five mental shortcuts I've outlined in the article. Unfortunately, it is also the most powerful, because our propensity to avoid ambiguity both feeds on and is amplified by the other tricks.
Consider why: A brain motivated to reach a conclusion in the face of conflicting evidence could easily resort to relying on only the most recent data (recency bias), clinging to a past decision (inconsistency avoidance), looking to an irrelevant outside factor as an indicator (influence from mere association), or holding on to a low-conviction, losing stock simply to avoid realizing the loss (the loss double-ouch phenemenon). To keep these ill-effects at bay, always remember that the best conclusion is often no conclusion at all.
Our brains are powerful tools, but they have their shortcomings. Since investing is all about good decision-making, you want to make sure your mental gearbox is in top working order. As you process information, I encourage you to keep your brain's mental gimmickry in mind. Your brokerage account will thank you.
Neither Alex Pape nor The Motley Fool owns shares of any company mentioned. Follow all of Alex's thoughts and trades on Twitter.
Get info on stocks mentioned in this article: