1. Don’t Confuse Me with the Facts—My Mind’s Made Up!
In a previous article, we discussed how the Reflexive Brain rapidly reacts intuitively to selective input,
without the time-intensive reasoning of the Reflective Brain. The Reflective Brain then processes the
input, often being overwhelmed by the response of the Reflexive Brain. In essence, the Reflexive Brain is
what keeps us alive while our Reflective Brain thinks.
Cognitive psychologists have identified ways that the Reflexive Brain reacts intuitively. While these
intuitive behaviors are good for many parts of our lives, they can cause us to react illogically when our
finances are involved. Cognitive psychologists refer to these intuitions as biases, and they label them:
heuristics, overconfidence, mental accounting, framing, representativeness, conservatism, and
disposition effect. This article will introduce the first two.
Heuristics
Rules-of-thumb allow for quick decision making. However, they generalize on generalities—they may be
a good place to start the reasoning process, but they are rarely the best answer in themselves for
financial issues.
An example of a rule-of-thumb is the 1/N rule. With N choices, you select 1/N of each of them. If the
retirement fund has 3 investment choices, the first inclination is to put 1/3 into each one. In financial
practice, a portfolio with 1/3 bonds, 1/3 U.S. stocks, and 1/3 International stocks would be appropriate
for a small segment of all participants in such a retirement plan.
We find corollaries to the 1/N rule. The first is “option overload.” We like choice; it lets us allocate 1/N
where possible. However as N increases in value, we become overwhelmed. For example, watch a young
child in a bakery who is told he can have only one choice—I have actually seen children break down and
cry because they can’t make a selection. When the child makes a choice, he often regrets the decision
once he receives his chosen pastry. So, too, retirement plan studies demonstrate that the percentage of
participation goes down as the number of investment options go up.
Another corollary is the “urgency imperative.” If we are told that we are about to lose a choice, we react
irrationally. This is what hucksters count on when they tell you that “if you decide in the next 20
minutes, you get a bonus.” We instinctively want to act so we don’t lose the bonus. Or, current investors
will consider putting more money into a mutual fund because it is closing. We don’t want to miss the
opportunity to invest.
Overconfidence
Jason Zweig, author of “Your Money & Your Brain: How the New Science of Neuroeconomics Can Help
Make You Rich” (Simon & Schuster; 2007) makes the observation, “One of the most fundamental
characteristics of human nature is to think we’re better than we really are.” He includes the following
example in his book: in 1965, psychiatrists Caroline Preston and Stanley Harris published a study in
which they asked 50 drivers in the Seattle area to rate their own skill, ability, and alertness the last time
they drove. Just under two-thirds of the drivers said they were at least as competent as usual, describing
their ability as “extra good” or 100%.

2. However, these 50 drivers were all interviewed in the hospital—they were there because their last drive
ended in an accident. The Seattle police reported that 68% of these drivers were directly responsible for
their crashes, 58% had at least two past traffic violations, 56% totaled their vehicles, and 44% would
ultimately face criminal charges. They suffered concussions, facial trauma, a crushed pelvis and other
broken bones, and severe spinal damage. Three of their passengers had died.
These drivers are not delusional. We naturally think we are better than we really are. Preston and Harris
also interviewed people with a clean driving record—93% believed themselves to be above average
drivers. Statistically, only 50% can be above average.
Overconfidence demonstrates in a number of ways. Firstly, we overestimate our chances at success,
leading us to take risks we regret down the road. Secondly, we have “home bias.” We trust in what is
familiar. Therefore, an investor tends to overinvest in their company’s stock, and invest too little outside
their industry, region, or nation.
Thirdly, we have the “illusion of control.” Investors demonstrate this by putting too little effort into
planning ahead, and are overcome by surprise when their investments don’t meet their objective. We
see it in the husband who won’t buy life insurance because his wife’s best policy is her own good looks.
Fourthly, we have “hindsight bias.” We laugh when the clueless person on the sitcom says, “I knew
that.” In reality, once we learn what did happen, we look back and believe that we knew it was going to
happen all along. For example: Psychologist Baruch Fischhoff ran a study on hindsight bias. Right before
Nixon’s trip to China, dozens of Israeli university students were asked to predict the probability that his
visit would be a success. Then, at two intervals after his trip, they were asked to recall their earlier
forecasts of what would happen. The trip had as much chance of turning out a disaster as a success. In
fact, it was wildly successful beyond all imagination. Less than two weeks after Nixon’s visit, 71% of the
students remembered predicting a higher probability of success than they actually had. Four months
after the visit, 81% claimed to have been more certain it would succeed than they really were at the
time.
The intuitive shortcuts of heuristics and overconfidence can trip up an investor who is unaware that they
exist. Such biases lead to financial mistakes such as over-concentration or failure to act. Worse, it can
cause our clients to forget how they failed to follow our recommendations and wrongly give them the
impression that they foreknew downturns and blame us for not acting. It is important for advisors to
document their recommendations, use an Investment Policy Statement that specifies diversification,
and review these documents regularly with our clients. Even more important, we must check ourselves
to make sure we don’t fall into the traps of overconfidence.
We will discuss other Behavioral Finance biases in future articles.