In this episode of Industry Focus: Healthcare, Motley Fool analyst Kristine Harjes is joined by contributor Todd Campbell to investigate the relationship between psychology and investing and explain how you can outsmart your biases.

A full transcript follows the video.

This video was recorded on April 5, 2017.

Kristine Harjes: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your Healthcare show host, Kristine Harjes, and it is April 5th, 2017. I have Motley Fool healthcare contributor Todd Campbell on the line. Todd, what's new? What are you writing about lately?

Todd Campbell: There's so much going on right now, especially in the healthcare space that you and I have talked about. I think it's going to be a really fun show today, because we're going to step back from everything and help investors get a better idea of how better to digest all that information and turn it into profit.

Harjes: Today's episode is going to be a little bit different from usual, as you mentioned. I'm excited for it. We are going to be exploring cognitive biases. Why is the human brain sometimes, maybe even most of the time, not perfectly logical? If you think about it, this explains why we are able to make money in the stock market to begin with. If you've studied economics, you know the efficient market hypothesis, that all the information out there is already factored in, and things are priced exactly as they should be. But we also know that there are ways to make more money than the average stock index in the market. That's because people control the market, and they are not always rational. If you think that psychology doesn't actually have that much to do with investing, consider that in 2002, the winner of the Nobel prize in economics, Daniel Kahneman, was actually a psychologist. In fact, his work has influenced just about everything we're going to talk about today.

Campbell: I think, Kristine, it's really interesting to think about the connection between the way that we think about the world or the way our bodies or brains work and the decisions that we end up making. I also find it interesting to think about how do we get to the point where we decided on tackling this kind of a subject on our show. I think it really stems from the fact that you and I were having a discussion about risk and how people view risk in their decision making, and arguably, when it comes to risk, we talk a lot about biotech, and perhaps there's no other industry in the market that presents a similar type of risk-reward that could lead us to make good or bad decisions, depending on how we view the information that's put in front of us.

Harjes: And we say all the time that you need to take your emotions out of investing when we talked about how volatile biotech in particular gets. But there are some specific ways you can do that once you understand your brain a little bit better.

Campbell: Kahneman's work was pretty groundbreaking because... what I find most fascinating about him was that he tackled the subject of utility. He basically looked at economic theory and said, "We should all act for our best economic interest, but oftentimes, we don't." And once he realized that and said that, he went out and tried to figure out why that is. Why is it that sometimes we make decisions that are not in the best interest of our wallet?

Harjes: Exactly. And even in terms of basic probability, sometimes people don't make the best decisions, whether it has to do with utility, or if it's even more straightforward than that. I figured I would kick us off with an example that shows that humans are pretty terrible statisticians. Todd, have you heard of the Linda problem?

Campbell: I have.

Harjes: OK. For our listeners, if you haven't heard of this problem, here's the quick and dirty. Linda is, in a survey, described as 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations. Which is more probable? -- the survey respondents were asked -- No. 1, Linda is a bank teller. Or, option No. 2, Linda is a bank teller and is active in the feminist movement?

Campbell: Yeah. Give our listeners a second to digest that and to weigh in with what they think is the most probable answer.

Harjes: All right, listeners. Take a second and hit pause if you haven't actually come to a conclusion yet. The answer is, it's more probable for her to be a bank teller, simply because it's impossible for No. 2 to be more probable, because in order for her to be option No. 2, a bank teller and active in the feminist movement, she has to also be a bank teller. But, the fascinating thing here is, 85% of survey respondents incorrectly chose option two instead of option one.

Campbell: They had all this information put in front of them, and they jumped in and said, "I have this information, so therefore I am now able to make a better assessment," forgetting the logic behind how probability works. As you add more characteristics, by definition, it's going to become less probable.

Harjes: You're completely correct. And it's crazy, because you read an example like this, and you're like, "Oh, I would never do that." But, I know at least for myself, when I was putting together notes for today's episode, I am guilty of just about every single thing that we are about to say.

Campbell: All of these things, it's almost like they are hardwired into us, and we have to literally slow ourselves down in the way that we're thinking. One of the things that he wrote about or talked about a lot throughout his career, Kahneman, is that there are two systems for thought. You have the first system, which is fast, it's instinctive, it's emotional driven. The second system is slower, it's more deliberate, it's more logical.

Harjes: Getting into some specific logical fallacies that come as a result of the way that your mind is set up with these two systems, the first one that we want to bring up is called anchoring. Todd, do you want to kick that one off?

Campbell: Did you look at the stock market closing price yesterday?

Harjes: No, I didn't.

Campbell: All right. A lot of people probably did, and they're probably viewing today as either bargain-priced or not bargain-priced based upon whatever the recent price was that they saw of the S&P 500. Or they're doing it with individual stocks or whatever. They're anchoring their perception of what's going on now to an arbitrary point in time that they selected, be it yesterday or the day before or the week before.

Harjes: The principle of anchoring is that you can be influenced by somewhat arbitrary numbers when you're looking at a relevant number. It doesn't matter if the number that you were looking at is somewhat related to the current situation or if it's completely just a random number that was flashed in front of your computer screen for a second before you then looked at, say, the share price of a given stock. The point is, the brain does anchor on to this number that it saw, and then everything that it sees after that, it sees with reference to that number. It's very easy to be tempted to catch what we call falling knives, which are stocks that are plunging, because let's say you've been watching a stock for a month and it's 20% lower than it was. It's pretty easy to think that must be a bargain, because that 20% lower number is a good deal lower than the original number. But, you need to look beyond that, and try not to get too caught up in framing your current valuation based on a previous valuation when the situation may have changed, and that sort of plunge might be warranted.

Campbell: It's hard to say where you might find value in that, or where the bottom may be established in there. I always think of Valeant (NYSE:BHC) when I think about anchoring, and saying to myself, what's the right price for Valeant? Was it $150? Was it $110? Was it $80? Was it $70? Was it $60? Was it $10? And depending on when you looked at the stock, it's going to influence your decision of whether or not you think it's a deal, a bargain, or not. That's why you have to step back from that and so down and say, "I have to understand the story better, I have to not jump to a conclusion too quickly on this. I have to understand why the stock is falling, rather than be anchored to this perception of this number that I saw at a point in time."

Harjes: Heads-up for listeners: We will probably be referencing a bunch of different healthcare stocks and stories we've covered in the past. If the quick recaps leave you wanting more, or you're not as familiar with the backstory, shoot me an email at industryfocus@fool.com, and I'll send you either a past episode if we talked about it on the show, or I can at least send you some relevant articles, because we have a lot to cover, so we're going to try not to get too in the weeds about any specific companies. So, yes, from there, let's move on to another concept. This one might be the most important of all of the ones that we're going to discuss today, and this is a loss aversion. The principle behind this one is people will act to try to minimize their losses more than they will act to attain gain, because it hurts more to lose $10 than the magnitude of the good feelings from winning $10.

Campbell: And when you look at the other way, once you've made your decision, if it turns out to be wrong, you tend to view things more optimistically than you should. So, there's two components to that, "OK, I'm going to make a decision that throws out logic because I'm afraid of losing." If I have $500, I could make $500 or lose $500. It's the same amount of loss or gain, yet you're going to not make the trade because you don't want to lose the $500. Well, if you make the bet, you're more likely to think the bet will pan out than it's not, and that's not necessarily true.

Harjes: Exactly. And very much intertwined in there is the sunk cost fallacy, which is what you're alluding to there, where if you've already purchased into a stock, you might be less likely to sell it and buy something else. I am absolutely, totally guilty of sitting on losers that I know I would never buy into at the current price, but yet I'm still sitting on them like, "OK, maybe it'll turn around eventually." But once I sell, I'm locking into that loss.

Campbell: I bet you every single listener out there right now that has a portfolio that has different investments in it is sitting on a few of these stocks, Kristine. You and I are not alone in this.

Harjes: It's so prevalent.

Campbell: We always used to joke way back in the day, it's the hope and prayer method of investment management, where you buy the stock and hope and pray that something happens to make it go up, because all it's done is gone down. And like you said, I have no interest in going out and buying it now, because the catalyst has changed or whatever. Yet, why is it that I'm so afraid or unwilling to take the loss, admit defeat, move on to another, better idea. In the healthcare space over the past couple years, Kristine, you and I have talked about various stocks. Two that jump out, one was a complete disaster, and the other was a temporary disaster that's building back up. Those were Ophthotech (NASDAQ:OPHT) and Portola Pharmaceuticals (NASDAQ:PTLA)

Harjes: We both for shareholders, right?

Campbell: Yeah. We both owned it. We talked about it different times on the show. Ophthotech had an interesting drug in phase 3. That trial was a miserable failure and the stock lost the majority of its value. Then, you have Portola that had a couple FDA decisions that were postponed. So, you had to look at it and make a decision based on that story -- had the catalyst changed to that story that would make you want to sell or not sell? In my view, the Ophthotech catalyst had changed significantly, and there's no reason to continue to hold it. But in Portola, the catalyst had just been pushed back, so there is a reason to hold it.

Harjes: Right. That's another reason why it's so important to keep an investing journal, write down why you're buying into these stocks and what could potentially change the reason that you have for holding them. That way, you can easily reference it, and hopefully you'll be more inclined to sell a loser that deserves a sell.

Todd, let's dive back into some of the more cognitive biases. Talk to me about framing.

Campbell: Framing is something that we absolutely have to pay attention to, especially as biotech investors, because we're always receiving, on a daily basis, press releases from companies that we may be interested in. And if we don't understand that there can be some framing of words or numbers that would be more inclined for us to view them favorably, then we might fall victim to that bias and ending up going out and buying when maybe we should dig deeper and not do that.

Harjes: A quick background on what this concept is, here's an example for you. When asked if people would opt in to this semi-elective surgery, some people had the surgery described to them as having a 10% mortality rate. Other people in the study had it described as having a 90% survival rate. That's 10% mortality vs. 90% survival. That's the same thing, but it's phrased in very different ways. Turns out, more people elected for the surgery when it was described as having a 90% survival rate. So, that's in the world of healthcare, but not necessarily investing related. How could that possibly apply to investing?

Campbell: I think there's a few different things. One of the things that jumped right out to me is the shift years ago, especially when we're talking about the internet boom. I'm dating myself a little bit. A lot of the press releases shifted from talking about their earnings per share to their EBITDA figures -- so shifting the focus away from traditional net income toward these other measurements that they wanted us to believe were equally as valid. Unfortunately, when the internet boom became a bust, we found that there really is no substitute for good old-fashioned net income and net earnings. There are a lot of different times as a biotech investor where you're going to look at a press release and try and digest the meaning of it. Make sure that you always slow yourself down, and don't jump to conclusions about the findings. Make sure you try and get as much information as you can before doing that, because it could very well be that they're putting their best foot forward, and that's going to fake you out.

Harjes: And I don't think that there's any malicious intent there most of the time. It's just kind of a fact that the positive news is going to come out first, whether it's in a press release or the earnings call. These companies are going to say the best things first. That positions you to have a positive idea of the company, and prepares you to hear, maybe, the bad news in a more positive way.

Campbell: True.

Harjes: Next bias that we want to talk about is called the confirmation bias. If anybody was on our website on April 1st, you may have seen our April Fool's Day joke, which was called The Motley Fool Echo Chamber. It was a very elaborate and well done -- snaps for that team -- joke construction where you would click on the top-of-site article and it would take you to the Echo Chamber, which was this tool you could use to refine the way news was presented to you such that it would only send you things that you already agreed with. Of course, this was a joke. We were playing on news lately, and some various things that we've all seen going on. But there's a lot of truth to that. You are more likely to click on an article that has a headline that you agree with. Or, even if you read something you don't agree with, you're more likely to dismiss it as flawed, rather than truly considering any contrary evidence to what you currently think.

Campbell: Kristine, I got so faked out by that April Fool's joke.

Harjes: [laughs] Did you? You work for The Motley Fool! You know it's April 1st!

Campbell: I know. And every year, listeners, they do something special like this. And yet I got sucked in and was like, "What?!"

Harjes: [laughs] That's kind of awesome.

Campbell: When I was thinking about confirmation bias, the first thing I thought of was a quote by Voltaire, which was, "Illusion is the first of all pleasures." What I think Voltaire was saying there was, we get incredible joy and happiness from interpreting information that backs up what we already believe. That is extremely risky as investors. Maybe less risky if you're just buying the S&P 500 index fund. But if you're buying individual stocks, you want to have divergent thoughts, you want to listen to people who are approaching things differently than you are, because it will either solidify your argument or it will lead you to a new argument. And I think that's incredibly important for investors to generate long-term success in the markets. Because, the reality is, it's very easy to think you're the smartest stock picker in the world when the stock market is going up.

Harjes: Exactly. So, avoid confirmation bias if you can. It's pretty impossible, but at least being aware of it, maybe you can try. That's what The Motley Fool is here to help you do, by the way. If you go to our website, you can almost always find conflicting views on various stocks. We are a very motley company, so we have people that are bulls and bears on the exact same stock. Anyway, the next bias we want to talk about is the peak-end rule, which is something I will tee off by talking about a 1993 Kahneman study that showed that participants that were exposed of 30 seconds of 14-degree ice water, which is super cold, rated the experience as more painful than participants that were exposed to 60 seconds of 14-degree ice water plus 30 additional seconds of 15-degree ice water. In other words, participants found that 90 seconds of ice water exposure was actually less painful than 60 seconds of pretty much equally cold water, just because the 90-second exposure ended with a somewhat warmer temperature water.

Campbell: Yeah. And we're only talking about one degree. For some reason, that was enough to offset the extra 30 seconds of freezing cold water. Kahneman also referenced another study -- I was just watching a TED Talk that he hosted and it was fascinating. Check it out, listeners, if you can -- the example he gave there was about colonoscopies. Essentially, what happened was, the same exact funny. People who had a shorter colonoscopy and people who had a longer colonoscopy, but in the longer colonoscopy, there was less movement of the instrument, etc., so there was less associated pain with that additional time. Sure enough, people walked away thinking, "That was less painful," even though, by all measures, they were exposed to a longer period of discomfort. I think it's a very interesting finding.

Harjes: So, the point of it is, the way that you remember experiences in your life has so much to do with the very final moment of that experience. So, how does that relate to investing?

Campbell: He talks a lot about happiness, and how it's not about the experience, it's about, like you said, what we remember in the last final thing of it. One of the things he'd mentioned was, someone had told him about how they had gone to the symphony, and the symphony was phenomenal, it was the best symphony ever for 15 minutes, and it ended with this big screeching noise, and that ruined it for him, because the only thing he could think of now was the screeching noise, not the 15 minutes of enjoyment. I think what we have to worry about is looking at it and saying, "I either lost money or made money on this stock at this point in time," and forget all of the other things that went into the decision-making process, the other variables that could have affected whether or not the stock rose or fell in the period. You have to consider the experience, too. You can't just focus on the end result.

Pro tip for listeners: You've already mentioned it once: Journal, journal, journal, journal. It's so important to write down why it is that you're buying a stock, and keep track of how it's going and things that are happening. That way you can go back and look at it and relive the experience of it, and not just have that final takeaway of "Oh, I lost money," or, "Oh, I made money." The other pro tip I would give out was that Kahneman's advice was to frown, because he found that if you frown, you are more willing to be critical of the information that you're being presented with. So, normally, I would say to smile more. But maybe, every once in awhile, throw a frown on your face if you're looking at information about a stock you hold, and maybe you'll come to a new conclusion.

Harjes: That's super interesting. I think the next thing we want to talk about is pretty related to that, because this peak-end rule says that you most easily remember the very end of an experience. The next thing we want to talk about has to do with, how easy is it to think of an example that is relevant to the question that you're trying to answer? This is called the availability heuristic. For example, you might be looking into a drugmaker that makes something for one specific disease, and you're watching the company's numbers get bid up and bid up. That could actually just be because a company working in a similar space but with a totally different drug is seeing positive results. So, the way the availability heuristic plays in there is, it's easy to think on the top of your head, "I just saw a positive diabetes results the other day, this unrelated diabetes company must be onto something good," and bid it up. It can be difficult recall the entire spectrum of everything that's ever happened. In fact, that would be totally impossible to do. But, the problem here is, we can rely a bit too much on the things that are readily able to be recalled.

Campbell: And one of the things, Kristine, I wanted to mention too, I worry that people are going to fall into this trap for this bias when they're looking at and hearing about marijuana, and the reform that's going on with marijuana laws. A lot of positive momentum for passing these laws, and talking about the potential market opportunity for marijuana stocks. It would be very easy for people to take a brush stroke and say, "All of these marijuana stocks are going to do well," when the reality is that very few will end up being the winners.

Harjes: When one issue is in the news a ton, it's so easy to think that it could impact your investment. But realistically, lawmakers could be completely focused on different issues. And news actually does relate to this quite a bit. For example, when you think about media coverage of different diseases, it can sometimes drastically impact your view of the market. And I think people are sometimes more inclined to bid up shares of companies that are working in diseases that are getting a lot of coverage as opposed to ones that might actually be much more prevalent and have a lot larger of a market, but you don't really hear about as much. The example that came to mind for me was diabetes spending vs. spending on ALS, which is Lou Gehrig's disease, it's the one you heard about with the ALS Ice Bucket Challenge. ALS spending annually is estimated to be between $256-433 million nationally. If you look at diabetes, just the direct medical costs are $176 billion, every single year.

Campbell: Yeah, it's a tremendous, huge market. The thinking there would be, "Any stock that has anything to do with diabetes is going to be a stock that I want to own." Or, if you happen to be looking at a stock and you happen to see the word diabetes and you just read an article about the diabetes market, you're more likely to be positively influenced in your assessment of that stock. And that's risky. So, make sure you're slowing down, maybe frowning little bit, and thinking about the experience in all of the two plus twos, not just the end result, whatever that number might be at the end of the calculation.

Harjes: Right. We are almost approaching the end of the episode. We have one more cognitive bias to share. This one is called substitution. It's basically replacing a complex issue with something simpler, because your brain is kind of lazy, whether you like to believe it or not. The way that I've heard this explained before is, it's an issue of changing a question like, "How happy are you with your life?" Which is a very complex question. You will instinctively turn that into, "What's my mood right now?" Which is an easier question to answer.

Campbell: Yeah, substitution, picture a tab, and you have a check mark in this column and a check mark in the other column, and it's all based upon, the example, the memories, not the experiences. My final memory of the symphony, that was negative, so I'll put that in the negative camp. It's easier to say, "I don't want to go to the symphony now because I had a bad experience at the last one," but that's not necessarily the way that it is. Taking a look from a healthcare perspective, saying, "OK, do I really want to dig in and figure out how Gilead Science's clinical stage drug for autoimmune disorders is really impacting the central nervous system or immune system, or whatever? Do I want to just say that they've done a great job in the past, so I'm going to assume that they have the management there to figure it out?"

Harjes: Right. Going back to the Linda problem from the earlier part of this show, Kahneman and his research partner, Amos Tversky, argued that in judging whether or not it's more likely for Linda to have been a bank teller or a feminist bank teller, the people in the study relied on resemblance between Linda's personality and her behavior. So, that's an example of substitution, because the people who were asked that question turned it from an issue that was a probabilistic calculation into one of simply just matching up causes and effects. So, I guess, to end the episode today, the last thing I wanted to touch on is, we're biased even after being told that we're biased. This is kind of crazy, but here's one final experiment for our listeners to chew on. Kahneman describes an experiment known as the Invisible gorilla. In this experiment, participants watched a short film of two teams passing basketballs. One team was wearing white shirts, the other team was wearing black. The viewers of the film were instructed to count the number of passes made by the white shirt team, and ignore the players that were wearing black. Halfway through the video, this woman is wearing a gorilla suit, she appears and crosses the courts, she thumps on her chest and moves on. The gorilla is in the frame for about nine seconds. And thousands of people have seen this video, but because they're so completely absorbed in the counting task, about half of them don't notice anything unusual when they're asked afterwards. And, even more interestingly, people who miss the gorilla are initially extremely stubborn, saying that there was no gorilla. So, after you've listened to this episode, I would encourage all of you listeners to go through your portfolio, your track record, your diary of investing thesis, which you hopefully have, and try to spot the cognitive biases that may have subconsciously influence you. You may be surprised how many gorillas are lurking in plain sight. Todd, thank you so much for doing this episode with me. I have had a blast.

Campbell: It was a lot of fun.

Harjes: As always, people on the program may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. Today's episode was produced by Austin Morgan. For Todd Campbell, I'm Kristine Harjes. Thanks for listening and Fool on!

Kristine Harjes owns shares of Gilead Sciences and Portola Pharmaceuticals. Todd Campbell owns shares of Gilead Sciences and Portola Pharmaceuticals. The Motley Fool owns shares of and recommends Gilead Sciences and Valeant Pharmaceuticals. The Motley Fool has the following options: short June 2017 $70 calls on Gilead Sciences. The Motley Fool has a disclosure policy.