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How Thinking
Affects Investing

Heuristics and Cognitive Biases

As a general rule, most of us are poor investors. This is because we often make decisions so as to minimize emotional discomfort. As such, we depend too much on our feelings and our intuition when, instead, it would serve us better to cultivate the skills of dispassionate appraisal and rational thinking.

Why should this be the case? The answer has to do with how we think about most things most of the time.

It is the nature of being human that we are called upon to make innumerable judgments, minute after minute, day after day. To do so, we depend on what psychologists call HEURISTICS: mental shortcuts that underlie our decision-making processes. Some heuristics are innate, hard-wired into our brain when we are born. Others are based on our experience and are learned as we mature.

We use heuristics many times a day, unconsciously and automatically, whenever we need to solve a problem, understand something, or make a decision. Doing so enables us to make good decisions quickly, often with minimal information.

For example, early one morning you are jogging along a narrow sidewalk and you see someone walking towards you. Without thinking, you move to the right, so the two of you can pass one another uneventfully. This is a heuristic. Later that day, during lunch, someone serves you some fruit, which you notice is covered with a greenish-blue mold and smells funny. You decline to eat it. This, too, is a heuristic. That night, as you are driving home from work, you notice you need gas. You drive to a corner where there are two gas stations. As you approach the corner, you quickly look at the signs and drive into the station with the least expensive gas. You are following a third heuristic.

Heuristics enable us to pass through life smoothly and quickly, from one moment to the next, without having to stop and think deliberately about every action, every judgment, and every decision. Obviously, such quick, automatic actions are helpful, even crucial to our lives and to our well-being. However, heuristics are often imperfect and sometimes irrational. Moreover, because we apply them automatically, it is easy to make poor decisions without being consciously aware of what we are doing.

Along with heuristics, we are influenced a great deal by what psychologists call COGNITIVE BIASES: distorted patterns of irrational thinking that lead to poor judgment. Where heuristics are often useful to our lives, cognitive biases are almost always harmful in some way, as they blind us to the reality of the problem at hand.

The combination of heuristics and cognitive biases is particularly powerful when it comes to thinking about money, especially when we are investing. For example, consider the following question: You own 100 shares of a stock that has gone up a fair bit since you bought it. Lately, however, the price has gone down. How do you decide when it is time to sell?

Knowing when to sell a stock requires you to guess what is going to happen. If you think the value of the stock will go down, you will sell now. If you think the value of the stock will go up, you will wait to sell. Since you don't know for sure, however, it is likely that you will fall back on one or more heuristics and cogitative biases to make your decision. Moreover, as you do so, you won't even be aware of what you are thinking or why.

Much of the investing I do involves selling short-term options based on one particular stock that is especially volatile. This work requires me to watch the stock's price very carefully, often from minute to minute. As such, I can tell you categorically that stock prices are notoriously unpredictable. Sometimes they will cruise along quietly for hours, or even a few days, with only minor movement. Every now and then, however, at unpredictable intervals, there will be significant changes within a short time, sometimes within a few seconds.

Nevertheless, it is important to me and the people I work with to anticipate the short-term price changes as best we can. Since no one can predict the future, this often tempts us to make decisions based on an intuitive feeling. If we guess right and we do our job skillfully, we make money. If not, we lose money (and, in the option-selling business, it is possible to lose a lot of money quickly).

Intuitive feelings notwithstanding, when I trade, it is important to me to be as rational and unemotional as possible. This only makes sense: the market itself is unemotional, if not rational.

For this reason, I have spent a lot of time thinking about the heuristics and cognitive biases that color my thinking, so I can eliminate them as much as possible. I would now like to share my thoughts and my advice with you.

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