Over time we develop short cuts, rules of thumb, to make decisions in complex and uncertain environment. The short cuts we take almost never result in the best decisions, but most of the time they are good enough.
Sometimes we try to make the absolute best decision, and we end up paralyzed. To avoid the paralysis by analysis, we often decide that good enough is good enough. If we were as rational as many of the classic economic models assume, we would take all the relevant information, study it, and make the optimal decision for each given circumstance.
Let me share an example that I heard from Andrew Lo of MIT:
Each morning I have to select a specific set of clothing from my closet. I have five jackets, 10 pairs of pants, 20 ties, 10 shirts, 10 pairs of socks, four pairs of shoes, and five belts. How many unique combinations do I have to choose from? Exactly 2,000,000! Now suppose it takes one second to evaluate each of these combinations. In my case, a complete evaluation of all my choices – which is required if I am going to make the BEST decision – would take 23.1 days!
I am sure that we all get dressed faster than that. We simply decide on something to wear that will be good enough.
As we have evolved, we have learned to make choices quickly and in the midst of uncertainty. This process of taking mental short cuts is called heuristics. As well as the heuristic decision making process has served us in terms of avoiding death by saber tooth tiger, it causes some major problems when it comes to investing. One of the most notable is representativeness.
Representativeness refers to our tendency to try to make sense out our environment by looking for patterns in the recent past and then projecting them into the future. Up until six days ago, (see what I mean by short term) we had all forgotten that good things happen. We had decided that because the news was all bad two weeks ago it, will be bad forever. When it is snowing outside, it is hard to believe that it will ever be spring.
Think about this for a moment: does it make any sense at all that when the S&P 500 was over 1,500 in early 2000 that we were refinancing our houses to invest in internet stocks? Look at the chart of the NASDAQ. At the time, everything was good. The news was good. CNBC said it was great your neighbor bought his own island with the proceeds of the latest dot com IPO. Can you remember what was said about the “old timers” that dared to question the new economy? Does it make any sense that late 1999 was a great time to buy, and now is a great time to sell?
Please understand, I am not suggesting that you buy right now. In fact, there might be legitimate reasons to sell now, but that is a decision best made in the context of a financial plan and clearly beyond the scope of this discussion. I am simply saying that we need to be aware of the process we are using to make the decision.
Just make sure that you are not falling for the classic behavioral finance illusion of representativeness.
