Watching the Oscars recently made me think about how much we humans love a good story. In fact, storytelling has been a part of our culture for as long as anyone can remember. We depend on stories to connect to others, share news, celebrate milestones, warn of danger, and protest perceived injustices (see the story of Natalie Portman’s cape at the Oscars for one example).
Stories also have an effect on our economy and the way we invest. In his book, Narrative Economics: How Stories Go Viral and Drive Major Economic Events, Nobel prize-winning economist Robert Shiller argues that actually studying the stories that affect individual and collective behavior can help us understand and prepare for major economic events.
In the world of finance, conventional thinking used to assume that investors were rational and could be depended on to make rational decisions. As such, experts reasoned that all existing information was baked into the investment process. Unfortunately, we investors often aren’t quite as rational as we think we are. For example, when was the last time a scary economic report made you think twice about your investing strategy?
Psychologists discuss two types of thinking that all of us employ when making decisions: reflective, in which a person evaluates the evidence and works to come to a logical conclusion, and reflexive or intuitive thinking, in which a person follows his or her gut to arrive at a decision. According to Cognitive Continuum Theory, these two opposite ways of thinking actually exist on a continuum, so it’s possible to approach a decision with some degree of logic and emotion.
Reflective vs. Reflexive Thinking: Spock vs. McCoy
If you’re a Star Trek fan, you may remember a stark example of reflective vs. reflexive thinking in the regular spats between the ever logical Mr. Spock, and the more emotional Dr. McCoy. Mr. Spock, half human and half Vulcan, approaches decision-making by applying logic and reason, often suppressing his human, more emotional side when determining the best course for the U.S.S. Enterprise and its crew. Dr. Leonard McCoy, on the other hand, despite being a man of science, often allows his passion to drive his decision-making. The “oil and water” combination of these two personalities serves to demonstrate the complex role that both reflective and reflexive thinking play in our collective psyche.
James Montier on behavioral investing
When it comes to investing, are you more of a Mr. Spock or a Dr. McCoy? Author James Montier, in The Little Book of Behavioral Investing, suggests we’re all a bit of both. He cites a simple three-question quiz, created by Shane Frederick, as one way to evaluate the ability of our reflective side to keep our reflexive, or emotional, side in check. Let’s see how you do!
- A bat and ball together cost $1.10 in total. The bat costs a dollar more than the ball. How much does the ball cost?
- If it takes five minutes for five machines to make five widgets, how long would it take 100 machines to make 100 widgets?
- In a lake there is a patch of lily pads. Every day the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long will it take to cover half the lake?
How long did you consider your answer to question number one? Did your gut immediately tell you the answer is 10 cents? If so, I’m sorry to tell you that your answer is incorrect ¬¬— it’s actually 5 cents. When Frederick first posed this question in a study at Princeton, he found that those who concluded the answer was 10 cents were significantly less patient than those who answered “5 cents,” and that reaching the right answer often requires a person to suppress the erroneous answer that springs impulsively to mind.
Tips From GMO On Reflexive Thinking
Let’s consider the second question. Was your answer 100 minutes? If so, wrong again! As Montier notes, if it takes five machines five minutes to produce five widgets, the output would actually be one widget per machine per five minutes. That means it would take 100 machines five minutes to make 100 widgets.
How did you answer the third question? According to Montier, the most common incorrect answer is to divide the number of days in half to arrive at the answer of 24 days. However, he writes, if the patch doubles in size each day, the day before it covers the entire lake, it must have covered half the lake, so the correct answer is 47 days.
When Frederick administered the test to 3,428 people in 35 separate studies, the results were interesting. Only 17 percent of the test subjects chose the right answer to all three questions, but a third of the group chose NO right answers. Montier decided to test 600 professional investors, including fund managers, traders and analysts, and found that only 40 percent managed to get all of the answers right, while 10 percent didn’t get any right!
Since we’re all human, and are all susceptible to the continuum of cognitive thinking, this just goes to show you that so-called money experts, including financial advisers like me, are just as prone to reflexive behavior as anyone else.
How To Think More Reflectively About Your Investments
Is it possible to overcome the trap of emotional thinking when it comes to investing? I like to think it’s possible to mitigate reflexive thinking, even if we can never fully overcome it. One way to do it is to work with an adviser to develop a sound investment plan based on the evidence, rather than on the headlines of the day. Keep that plan and use it as your touchstone for all subsequent decisions. Then, when new information (or marketplace noise) presents itself, challenge yourself to ignore your first gut reaction. Finally, use your adviser to hold you accountable by playing the devil’s advocate (you can do the same for your adviser!). A mindful, deliberate process will help you tell yourself a better investment story, and likely produce a better outcome in the long run.
About the Author:
Wayne B. Titus III, CPA/PFS, AIFA® founded AMDG Financial and AMDG Business Advisory Services in 2002 based on his fifteen years’ experience at two large accounting firms, where he worked with Fortune 50 clients. He dove into entrepreneurship to make a bigger impact on people's lives. As a fee-only fiduciary adviser, his loyalty is to his clients: he places their interests ahead of his own or those of his firms. With assets of more than $188 million, AMDG Financial integrates tax, financial and investment strategies to help clients make financial and life transitions successful on purpose. The company's credo is, "From financial wisdom, better stewardship.” His latest book is The Entrepreneur’s Guide to Financial Well-Being (Lioncrest Publishing, March 2019). To learn more, visit www.amdgservices.com.