The Hidden Influences of Your Brain: Part 1 – Behavioural Biases

posted on October 15th, 2015 by Bellmont Research Team

What time did you get out of bed this morning? How did you decide which sock to put on first? Did you have toast or cereal? Some of these decisions might have been made consciously. You set the alarm clock, for example. But many decisions are made subconsciously – the result of a habit, or an un-noticed behavioural cue, or a distant throwback to a something that helped our ancestors survive on the savannah perhaps.

What may surprise you is how many decisions fall into the subconscious category. While it is not precisely measurable, neuroscientists estimate that 80-95% of decision-making occurs subconsciously. That’s right – despite our internal dialogue and subjective reality that tell us we are the masters of our own minds, the reality is otherwise.

Over the next 5 posts Behavioural Finance Australia will provide an overview of the hidden influences of your brain. The purpose is to help you to become a better investor. We will examine:

  1. Major decision-making biases that our brains expose us to;
  2. Common investment errors that result;
  3. Distortions these biases create on financial market prices and returns;
  4. Five tips on how to avoid investment decision-making traps; and
  5. How investors actually respond to these issues and opportunities today.

As we go, we will challenge you to identify hidden influences in a range of investment and everyday life scenarios. And we will seek your feedback about what you – advisers, accountants and investors – think is important, which we will summarise for you in Post 5. If you’d like to join us on this journey, you can start below, where we analyse Mark & Meg, a married couple as they decide to buy a new car.

Mark & Meg buy a car

Mark & Meg are a middle-aged professional couple in their 50s. Mark is a business banker at a major bank, while Meg works part time as a senior architect at a mid-sized local firm. With their mortgage now under control and the kids starting to become more independent, they feel it’s time to upgrade their car. It’s their family car, and Meg will be the main driver.

audiDrive to the dealer

On the way Mark & Meg discuss their preferred option – an Audi A4. It’s a stylish 4-door sedan that they both like. Meg’s parents have driven Audis for years and rave about how good they are. Recently one of the Meg’s friends bought an Audi A4, which Meg enjoyed taking for a test-drive.

What behavioural biases can you spot?

While recommendations from friends can be helpful, we tend to rely on social cues from others more than we should. In one famous study people were asked to judge which two of a small number of lines corresponded in length. It was an easy task, less than 1% of people got it wrong. However, to make it more difficult, the experiment was then altered. People were put in a room with 9 actors, each of whom chose before the test subject, and each of whom selected the wrong line. In that context, only 25% of people were able to consistently choose the correct answer. The surprising outcome from this study is that for most people, social influences are strong enough to overcome the clear objective truth. And, in case you are wondering, the social influence wasn’t just peer pressure – a similar effect was observed when subjects were told how others had responded, but were able to answer in private.

Being strongly influenced by our peers came in handy for our distant ancestors, much of whose brain structure is the same as what we now carry around in the modern world. The caveman who stopped to question why everyone was running, soon became dinner. If social influence is powerful where the correct answer is clear to the naked eye, we should expect it to be stronger in the complex world of investment decisions.

Parking the car

Mark & Meg soon arrive at the dealer and find a park around the back. As they step out of the car Mark notices something red on the footpath. He quickly recognises it as a $20 note. In one fluid motion he picks it up, shows Meg his lucky find, and happily plants in snugly into his wallet.

What behavioural biases can you spot?

Mark, and perhaps Meg too, are have been “emotionally primed” by this experience. Positive feelings associated with a small lucky find can have significant effects. In one study, subjects who found a small amount of money just prior to being asked to reflect on their life, reported being happier with their life overall than those who had not. The emotional priming can come from a range of sights, sounds and smells. In another study, being exposed to a happy face influenced people to drink more beer. This was effective even when they saw the happy face for no longer than a few micro-seconds – not long enough to even be aware they had seen it!

twenty

A significant part of our sub-conscious brains are used for processing emotions. Fear helped our ancestors clamber up a tree before they had been able to consciously process the sinister movement in the shadows. It is the protective effect of fear, in particular, that has made it one of the strongest influences on our behaviour, and one with significant implications for investment decisions and markets.
In Mark’s case, the positive emotion that results from his lucky find may lead him to be more confident in his decision to buy a car. Consistent with experimental evidence, it is not inconceivable that by finding $20 Mark is now willing to pay $1,000 more for the car!

Comparing options

Inside the dealer, the smartly dressed and well-spoken salesman, Paul, helps them understand the benefits of their proposed purchase. Mark is keen to understand the after-sales support that will be available. He recently read a story where the author had a scary experience with his Audi failing on a busy motorway. The driver feared for his life as he manoeuvred away from a looming truck and felt let down by Audi.

What behavioural biases can you spot?

Theoretically, to make a proper assessment, Mark should compare long-term reliability data across different makes and models. Instead, we tend to be influenced by vivid stories and personal experiences. The more vivid, emotional and personal, the greater the impact. This is why charities present pictures and stories of individual children, rather than statistics about the millions of needy. We are more likely to give money to help a single impoverished child, than to hundreds of their impoverished classmates.

car keys
There is a cluster of related cognitive errors here:

  • We are overly reliant on evidence from small samples of data.
  • We rely too much on recent experience and expect it to continue.
  • We overweight low probability outcomes and underweight almost certain outcomes.

In Mark’s case, these effects may make him feel Audi’s maintenance record is worse than it actually is. For investors, these biases contribute to the “value effect”, which we will explore in later posts.

Negotiating the price

Mark and Meg have decided. They are going to buy a black A4. It’s two years old and has done 38,554 kms. The sticker price is $45,000 (drive away, no more to pay), but Paul says he could talk to his manager about doing them a better deal.

What behavioural biases can you spot?

The sticker price may be unreasonable, but it will serve as a strong “anchor” for negotiations, drawing Mark & Meg’s estimates of value toward it. Anchors affect us, even if we believe we are ignoring them. For example, in one study real estate agents were asked to value a property. Some were given the vendor’s price estimate; others were not. Theoretically, it should not matter – the agents were asked to provide an independent appraisal. But it did. Those who were given the vendor price provided estimates significantly closer to that amount.

anchor
And anchors can affect us even if we know they are irrelevant – and even if we know they are completely random! Numbers that are shown to us as a result of spinning a pinwheel or rolling dice have been shown to affect our estimates of the proportion of African nations who are members of the UN, or the number of months jail time an offender should serve, respectively. For Mark & Meg, the sticker price is likely to act as the most salient anchor. However, given the evidence, it is not inconceivable than the 38,544 km on the clock will also have an anchoring effect on their estimate of value.

In the case of investors, the purchase price is a powerful anchor, helping to create the “disposition effect” – an investment patterns that we will explore in later posts.

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About the Author:

bfa

Simon Russell, Director, Behavioural Finance Australia
For news, articles & events related to behavioural finance, you can join Behavioural Finance Australia’s mailing list via their web site at www.behaviouralfinanceaustralia.com.au. BFA does not provide financial or tax advice. Please consult your appropriately licensed financial or tax adviser or exercise your own judgement prior to making any investment decision. Full terms and conditions are available on their web site.



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