During my journey as a stock market investor, the topic of cognitive biases has always fascinated me. According to Wikipedia, a cognitive bias is ‘’a systematic pattern of deviation from norm or rationality in judgment.’’ Cognitive biases are essentially perception errors that lead our judgment in the wrong direction unconsciously.
Here are some examples of cognitive biases:
- The fear of flying compared to driving a car, while the chances of dying by car accident are substantially higher than by plane (neglect of probabilities).
- In a game of heads or tails, the tendency to believe that after 5 consecutive heads, the chances of getting tails on the next toss increase (gambler’s fallacy).
- To see a stock you wanted to buy increase by 20% following a news release and to refuse buying it at a higher price, even if the fundamentals have changed (anchoring bias).
- In medicine, people who receive placebo treatments sometimes experience the same effects as those receiving the real treatment, simply because they believe in it mentally (placebo effect).
There are dozens of cognitive biases and they are the subject of many studies in psychology. In the investing space, it is surprising to see how investors can become irrational (to varying degrees) when you think about it. To succeed in the stock market, I think it’s important to be aware of the biases that can affect us and consciously try to push them back. This is not an easy task, but just being aware of them is already a step in the right direction.
The cognitive bias I want to share more details about today is extremely interesting: the complexity bias.
Essentially, the complexity bias is based on the belief that complex things are preferable to simple things. In some situations, the appeal of complexity is attractive because it rhymes with sophistication. Let me illustrate this point with an example.
Trip to Mexico
It is January, the month of new resolutions, and you decide that it is time to lose a dozen pounds before a trip to Mexico that you have planned in 2 months. You decide to go see two different nutritionists so that they make you a food plan and support you until you reach your goal.
During your first appointment, nutritionist #1 tells you that weight loss is extremely simple: eat fewer calories than you spend. To do this, you just need to focus on the basics: eat your fruit and vegetable servings, stop going to the restaurant 5 times a week and slightly reduce your alcohol consumption. He is highly confident that with his simple food guide, you will lose your few extra pounds at a rate of one pound a week.
You now go to your appointment with nutritionist #2. He tells you from the outset that the human body is obviously very complex, and that he has developed a revolutionary method to lose weight. It is based on more than 15 years of scientific studies and experiments. It turns out that nutritionist #2 has studied the effect on the metabolism of more than 300 foods and supplements ingested at various times of the day, depending on the season and the individual level of stress. He assures you that if you follow his system, eat according to the macronutrient ratios determined by his algorithms and take the supplements he recommends, you will lose weight in no time.
You know you have too much weight and want to be sure to lose it because you want to look good in your new swimsuit. Which nutritionist would you be tempted to choose? Regardless of your decision, you will agree with me that nutritionist #2’s method seems much more sophisticated than #1’s. Many people will choose #2 since they associate complexity with superior performance. Even if you do not really understand the science behind nutritionist #2’s technique, why would he bother doing so much if his method didn’t work, right?
But what does this have to do with investing?
In stock market investing, as in many areas of daily life, we tend to believe that complex strategies are the most successful. After all, the investment and finance worlds are complex, so they must need complex solutions to outperform.
The reality, however, is totally different. The reality is that complexity sells better. Whether it’s a book, a course, an investment strategy, a trading algorithm or the choice of a portfolio manager, we all want to feel like we are getting the biggest bang for our buck. If what we are paying for seems too simple, we have the impression that something better is probably out there somewhere. A much smarter individual must have developed a complex solution using more advanced knowledge than what we can comprehend. Complexity has something seductive that attracts us. We like the unknown…
“Simplicity is a great virtue but it requires hard work to achieve it and education to appreciate it. And to make matters worse: complexity sells better.” – Edsger W. Dijkstra
The simplicity of our brain
As Daniel Kahneman explains in his excellent book Thinking, Fast and Slow, the human brain is made up of two systems. System 1 is the fast, intuitive and automatic system that we use in all our daily activities. If I ask you how much is 2 + 2, the answer comes to mind immediately without thinking. System 2, on the other hand, is the analytical system, the one that processes more complex mental tasks. It also acts as a kind of supervisor for the intuitions of system 1. When we are offered a complex investment strategy, for example, it is primarily System 1 that considers the situation: “I do not understand this strategy, so the person in front of me must be much more competent than I am in this area.” Subsequently, system 2 comes into play and continues:” Since this person is more competent than me, and uses this investment strategy, it seems logical that I use the same strategy. ”
Opting for a complex strategy is actually a mental shortcut for our brain. Since we are unable to understand the basis of the strategy, we accept our ignorance and delegate responsibility to someone “more competent than us”. Conversely, a strategy that seems understandable to us would actually require more mental effort since we would be able to evaluate it thoroughly and consider its pros and cons. System 2 is unfortunately very lazy and prefers to accept the hypothesis that a complicated strategy must probably be better.
The biggest disadvantage of opting for a strategy that we do not understand is that we do not know the parameters that motivate the decisions to buy or sell (whether it be a specific security or an investment product such as an exchange-traded fund, mutual fund, etc.). During market turbulence, it becomes very difficult to assess whether it is time to sell, hold or buy more. In times like these, the investor becomes inclined to make bad decisions at the worst possible time. Afterwards, it is also difficult to evaluate what mistakes have been made and to learn from them.
Conversely, it is much easier to manage a strategy that we understand, not to panic during market turbulence and improve the strategy based on previous mistakes.
Keep things simple
We often try to find complex solutions to simple problems. A highly indebted person tries to negotiate a few dollars off her Internet bill while she does not realize she lives in a house well beyond her means and has a brand-new car that costs a fortune. Another person takes vitamins every morning to improve her health but eats fast food for lunch every day at the office.
The important thing, I believe, is to get back to the basics even if they are not spectacular nor will they be the envy of people around you. In many cases, simple things work just as well, if not better, than complicated things. A 2011 study titled “A Survey of Alternative Equity Index Strategies” has shown that simple investment strategies with little securities turnover perform equally well as complex strategies with a lot of turnover.
Long-time readers of our blog know that our investment strategy is relatively simple. We have a handful of fundamental criteria upon which we rely to determine the potential of a business. We rarely use extremely complicated financial models (although we are able to do so), because if we are the only ones to understand the science behind our analyzes, we will probably wait a long time for other investors to agree with us and for the stock price to move up. Unless, of course, the complexity of our analyzes induces our readers to follow us blindly, which would be a splendid demonstration of the complexity bias in action. But rest assured, that is not our intention.
To conclude, here are some points I suggest you consider in order to become more successful as an investor:
- Find a simple strategy that works
- Only invest in what you understand
- Learn from your mistakes and gradually expand your circle of competences
- Do not think that everything complex is necessarily better
Why make things complicated when they can be simple, right?