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The Psychology of Investing, Part 1 Overcoming Fallacious Thinking As an Investor

By David Gardner

Editor's Note: The following article is part of an ongoing series on the Psychology of Investing and was initially run as a Rule Breaker Portfolio report.

My thoughts on the psychology of investing are inspired by the book I'm reading at present, which is entitled Inevitable Illusions: How Mistakes of Reason Rule Our Minds. It was originally written in Italian by Massimo Piattelli-Palmarini in 1994, and is now available via paperback in translation.

The premise of the book is simple and compelling. Just as optical illusions exert a trick on our eye, so "cognitive illusions" exert a trick on our minds. Cognitive illusions involve the illusion of "knowing." As the author writes, "These are errors we commit without knowing that we do so, in good faith, and errors that we often defend with vehemence, thus making our power of reasoning subservient to our illusions."

As you might imagine, all of this couldn't be more relevant to us as Foolish investors. If we can train ourselves to break out of the "tunnels" of fallacious thinking -- tunnels, by the way, that are quite natural for us to go down, for they are rooted in the very stuff of human nature -- then we will be that much more effective as investors.

The first concept I'd like to deal with, then, is the concept of "framing" -- that the way we are presented information determines our reaction to that information.

The book lays out an actual case study taken from the field of medicine. Two different groups of doctors are presented with the same situation: a serious disease has a new form of treatment, an operation. Doctor Group A is told (factually) that there is a 7% mortality rate within five years of the operation, and we see from actual clinical data how many recommend it. Doctor Group B, on the other hand, is told (factually) that there is a 93% survival rate within five years of the operation... and we see how many of them recommend it.

You may not be surprised to find out -- and this is a real story, real clinical data, real recommendations -- that Doctor Group A hesitated to make favorable recommendations, while Doctor Group B was inclined to recommend the treatment. All this, despite no actual difference in disease or treatment -- two answers, for one reality. The doctors are guilty, in this case, of a cognitive illusion of which we ALL are by instinct guilty: framing.

As Piattelli-Palmarini writes, "Our problem here is that we do not compute final 'assets' (so to speak), but only departures from a baseline." Again, this is human nature, applicable to us all; I am choosing but one easy example. In this case, the baseline is "THREATENED, BUT HEALTHY, STATE." Doctor Group A is presented a frame that encourages them to think about a departure from the baseline (7% mortality rate), while Doctor Group B is presented a frame that encourages them to think about a proximity to the baseline (93% survival rate -- continued health). Human nature focuses us on how far we're departing from a given state or starting point -- not on the reality, the actual assets.

What is so crucial about this again is that we all instinctively make this mistake, suffer from this illusion. (This is one of numerous cognitive illusions documented in the book.) But if we educate ourselves and become conscious of this tendency, we can check ourselves and reduce the number of times we are "tricked."

Let's bring this back home to our topic: investing. One can already see many applications of this principle. Here are a couple. Imagine all the people who have been hoodwinked by mutual-fund advertising, and the unethical work of sales professionals, to believe the "baseline" is not the stock market's average (obtainable cheaply via a good index fund) but rather a certain return (say, double digits), or what happened last year. In other words, many in the past have been sold on this sales pitch: "But Doris, the fund did very well last year, up 17%." (The market, say, was up 28%.) Or: "But Doris, the fund may not have been very good in the past, but is having a great year this year." (Which again, frames things so that one year is taken out of context, and no consideration is given to the market overall.) These messages are "framed" off an incorrect benchmark; the reality, the true "asset" here, is the return of the index fund.

Many other examples of fallacious framing exist -- too many to do the topic justice in this short space. Another: Are you thinking that based on the market rising 20%+ four years in a row that this is a new legitimate expectation, an acceptable new benchmark? I don't think any true Fool is, but some others are. Actually, that rate is more than double the market's longer-term return of about 11%. We simply cannot and should not expect 20%+ is regularly sustainable.

I was reading our Amgen message board recently and a fellow Fool posed this question: "All of my research tells me AMGN is still good to be invested in, but the price has really dropped. I am planning to stay in, but what news caused this drop? A basic belief in [its being] temporarily 'overvalued'? Or some new competitor? Or a new head of FDA?"

The fallacy here is that the investor (not "minute-trader," not "speculator") has chosen two inappropriate benchmarks. The first is the price at which he bought, which the market neither knows nor cares about. The investor is in danger of judging the company or the business based on the price that he paid for it.

More important, though, is the second inappropriate benchmark: the length of time he has been invested. We must all ask ourselves: Over what time have I actually been invested, and do I feel that that is enough time to draw meaningful conclusions?

My answers to those questions with Amgen are that I've been invested for about five months, and five months is (for me) not a long enough period to draw meaningful conclusions, not an appropriate benchmark with which to "frame" my evaluation and decision-making.

"In the world of perception," Piattelli-Palmarini writes, "an [optical] illusion is to reality what a fallacy is to reasoning: an argument that is not true but has the appearance of being so. There is always some truth in any illusion; there is always some persuasion in a fallacy. Our business is to distinguish between angels and devils."

That is the purpose of my "Psychology of Investing" occasional series, and that should be your and my intention as we go through investing and go through life. The bad news is, there are numerous cognitive illusions that we all fall prey to, repeatedly. The good news is, we have thinkers like Piattelli-Palmarini to help us suss this out.

Next -- What's My Anchor?


The Psychology of Investing

  • Part 1 -- Overcoming Fallacious Thinking As an Investor
  • Part 2 -- What's My Anchor?
  • Part 3 -- Tails-Tails-Tails-Tails
  • Part 4 -- Are You Checking the Box?


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