Useful Biases

There was a time when psychology was all about helping people get from bad to normal.

How do you get depressed people to be OK? How do you make an insane person sane?

Psychologist Martin Seligman saw how limiting this was. The focus on mental illness and getting people from below average to “normal” ignored at least half the population who are already “normal.”

“I want to remind our field that it has been side-tracked,” he told the American Psychological Association after being named president. “Psychology is not just the study of weakness and damage. It is also the study of strength and virtue. Treatment is not just fixing what is broken; it is nurturing what is best within ourselves.”

That talk is seen as the birth of positive psychology – the branch of the field that tries to make normal people happier. The subtle shift from fighting bad quirks to realizing some quirks are helpful was important.

And it’s something we should learn from as investors.

Interest in investing biases exploded after the financial crisis showed investing has as much do with behavior as it does spreadsheets.

But not all biases are bad, and we can become side-tracked obsessing over mental errors like psychologists were 30 years ago.

Some biases – intuitions that aren’t backed up with facts – can be lifesavers.

You won’t find these biases in a textbook. I made them up. But that’s the point – we’re not discussing them enough, and underappreciating how helpful they can be.

1. Allergic to nonsense bias: An overactive nonsense detector that asserts extreme skepticism when confronted with financial salesmanship.

You can let your nonsense detector down around nurses, pilots, and bus drivers, because their personal incentive to deceive is near zero. But incentives can be so staggeringly high in finance that otherwise good, honest people become willing to spout nonsense and market wild ideas. This in less about poor morals and more about the power of beliefs to be shaped by paychecks and social status.

Lucky, then, is the person who navigates the financial world with an unrelenting ability to both spot and avoid nonsense. Nonsense can be anything from overconfident projections to accounting gymnastics to outright fraud. The common denominator in those allergic to nonsense is not intelligence or technical knowledge; it’s a belief that all business is hard and great business is very hard, so the default level of nonsense in a proposition should be proportionate to its marketing zeal.

This is a bias because not all marketing – even the aggressive kind – is deceiving, and everyone is in sales whether they know it or not. But skepticism up to the point of cynicism around sales can be a useful filter that saves you countless headaches.

2. Enjoyment bias: An inefficient investing strategy that you enjoy will outperform an efficient one that feels like work because anything that feels like work will eventually be abandoned.

Getting anything to work requires giving it an appropriate amount of time. Giving it time requires not getting bored or burning out. Not getting bored or burning out requires that you love what you’re doing, because that’s when the hard parts become acceptable.

It’s almost a badge of honor for investors to claim they’re emotionless about their investments. But if lacking emotions about your strategy or holdings increases the odds you’ll walk away from them when they become difficult, what looks like rational thinking becomes a liability. The key to a lot of things in finance is maintaining endurance when the tide goes out. Loving the companies you buy or the strategy you use is a bias in the sense that it doesn’t align with coldly rational thinking. But if an emotional attachment to your investments keeps you playing during hard times when it would otherwise be tempting to give up, it is one of the most useful biases that exists.

Same for the well-documented home bias. Investors overwhelmingly favor companies from the country they live in, ignoring the rest of the world. Is it rational? No. Is it useful? Yes. Being biased toward familiarity over opportunity is great if it offers the comfort and confidence needed to stick with something that has an uncertain future.

3. Reasonable ignorance – intentionally limiting your diligence in order to avoid decision paralysis in a world where everything, if you dig deep enough, is more complicated than it seems.

I knew an investor years ago who prided himself on leaving no stone unturned. He considered it his edge. At first I thought most of his diligence was an exercise in confirming what he wanted to know, but the reality was worse. He was wracked with indecision, because the more he dug the more complicated the story became.

Everything is like that. Brent Beshore put it best:

ALL BUSINESSES ARE LOOSELY FUNCTIONING DISASTERS, AND SOME ARE PROFITABLE DESPITE IT.

At 30,000 feet, the world is beautiful and orderly. On the ground, it’s chaotic and confusing. Nothing ever goes to plan. Surprises lurk around every corner. Things are constantly breaking. Someone is always upset. Mistakes are made daily. Expecting anything less is being out of touch with reality. And remember, just because you’re now aware of it doesn’t change reality. It was that way before, you just didn’t realize it.

You can’t ever know everything about a company because the deeper you dig you more you realize that things you thought were simple are actually endless webs of complicated people with different and shifting needs, held together by a precarious shared goal.

At some point decisions have to be made, which means pulling the trigger when you know there are things you don’t know and being OK with that. This is less about willingly closing your eyes and more about the realization that a few variables tend to dictate the majority of outcomes. Putting the odds of success in your favor is about understanding those variables while accepting the unknown baggage that rides along.

4. Historical discounting – the recent past is the most relevant, because the importance of what happened in the far past decays as the cultural and legal forces that triggered a specific event change over time.

A lot of things do not revert to the mean.

You cannot compare asset valuations today with the asset values in 1890, because so much has changed since then – accounting standards, information distribution, securities laws, the makeup of sectors, etc.

Same thing over shorter periods. Are college degrees worth as much today as they were even 15 years ago, before so many marketable job skills could be learned online for free? I don’t know. Maybe not.

It’s intuitive to look for investing patterns that have worked for decades or centuries. But there’s a balance between using enough history to ensure you’re not cherry-picking ideas while not using so much that you’re relying on outdated trends markets have adapted to. Blogger Jesse Livermore explained this so well:

Some investors like to poo-poo this emphasis on recency. They interpret it to be a kind of arrogant and dismissive trashing of the sacred market wisdoms that our investor ancestors carved out for us, through their experiences. But, hyperbole aside, there’s a sound basis for emphasizing recent performance over antiquated performance in the evaluation of data. Recent performance is more likely to be an accurate guide to future performance, because it is more likely to have arisen out of causal conditions that are still there in the system, as opposed to conditions that have since fallen away.

A good way to think about history is through the lens of Voltaire’s quote, “History never repeats itself; man always does.” There are timeless truths about how and why people do things you can learn from history. But understanding that things change and you should pay the most attention to your modern world is not an ignorance of history – it’s probably one of history’s greatest lessons.

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