Our brains are incredible things.
Every minute of every day our minds absorb tremendous amounts of new information.
Some of this information we consciously think about, question, work on, mull over, and attempt to solve.
However, the conscious part of our brain can only focus on one thing at a time. To make matters more complicated, we often have to think and act quickly.
So, our brains will often use shortcuts to help us out. These shortcuts are called heuristics.
These mental shortcuts are incredibly useful and they’re often very accurate. That’s why our brains evolved to use them in the first place.
Unfortunately for us, heuristics aren’t infallible. Sometimes things aren’t exactly as they appear on the surface (for example, a common situation has been slightly changed or is unique). In these instances, relying on heuristics can seriously hurt us and cause us to make bad decisions.
When our heuristics fail to produce a correct judgment, the result is a cognitive bias – which is the tendency to drawn an incorrect conclusion in a certain circumstance based on cognitive factors.
Cognitive biases can affect us in all aspects of life, from shopping to relationships, from jury verdicts to job interviews. Cognitive biases are especially important for investors, whose main goal should be to think as rationally and logically as possible in order to find the true value of a business.
Therefore, an awareness of the heuristics your brain uses and the cognitive biases they can cause is imperative if you want to be a successful investor.
If you’ve read Thinking, Fast and Slow by Daniel Kahneman (a book I highly recommend), then you probably already know some of the most important heuristics and cognitive biases that affect us nearly every day – and, importantly, that affect investors when we make capital allocation decisions.
However, there are dozens and dozens of different heuristics and cognitive biases that our brains can use. Wikipedia’s list of cognitive biases lists 175 different ones. That’s a lot of biases to be aware of.
Luckily, the list of cognitive biases becomes much easier to deal with if we can condense them into just several broad groups. Buster Benson over at Better Humans came up with four categories for the 175 possible heuristics and cognitive biases based on the problems that they help our brains solve.
The 4 Problems Heuristics Help us Solve
As Buster points out, every heuristic exists for a reason – primarily to save our brains time or energy. When we look at them based on the main problems that they’re trying to solve, it becomes a lot easier to understand why they exist, how they’re useful, and what mental errors (cognitive biases) they can introduce.
The four main problems heuristics help us solve are:
- Information overload
- Lack of meaning
- The need to act fast
- How to know what needs to be remembered for later
Problem 1: Too Much Information
Because there is just too much information in the world, our brains have not choice but to filter most of it out. Our brains use a few simple tricks to pick out the bits of information that are most likely going to be useful to us in some way.
- We notice things that are already primed in memory or repeated often.
See: Availability heuristic, Attentional bias, Illusory truth effect, Mere exposure effect, Context effect, Cue-dependent forgetting, Mood-congruent memory bias, Frequency illusion, Baader-Meinhof Phenomenon, Empathy gap, Omission bias, Base rate fallacy
- Bizarre, funny, surprising, and unique things stick out more than common, boring, expected things.
See: Bizarreness effect, Humor effect, Von Restorff effect, Picture superiority effect, Self-relevance effect, Negativity bias
- We use comparisons to evaluate similar things and we notice when something has changed (and we often make decisions based on the direction or magnitude of change, rather than re-evaluating the new value as if it were presented alone).
See: Anchoring, Contrast effect, Focusing effect, Money illusion, Framing effect, Weber–Fechner law, Conservatism, Distinction bias
- We are drawn to details that confirm our own existing beliefs and ignore details that contradict our existing beliefs.
See: Confirmation bias, Congruence bias, Post-purchase rationalization, Choice-supportive bias, Selective perception, Observer-expectancy effect, Experimenter’s bias, Observer effect, Expectation bias, Ostrich effect,Subjective validation, Continued influence effect, Semmelweis reflex