Are You Drawing The Wrong Conclusions When Investing?

November 20, 2012

in Investing

By Alvin Chow (guest contributor)

I learnt about the concept of mental models from my boss. He said that we use heuristics to form judgments or make decisions. Heuristics are rules of thumb used to shortcut the thinking process. He quoted the example of a kid learning about what a car looks like. Over time, based on observation, he would form certain rules like “has four wheels”, “has windows”, and so on to conclude that an object is a car, even though it is of different shape, make and color. We form such mental models in every area of our lives to aid us in making conclusions faster. If not, we have to spend a lot of time understanding a subject or an object over and over again.

The Ladder of Inference

Figure 1 – The Ladder of Inference

To understand how we form these rules, it is helpful to look at the Ladder of Inference. Let’s start from the bottom of this ladder. We pick out data we think is important to aid our decision making. Thereafter we add meaning to the data and make assumptions. After we draw enough conclusions, we form beliefs. We will always act according to our beliefs. And once we get results, we select the results that we seek, to reinforce our beliefs.

I would use my colleague’s example. He has a belief that “all women are bad drivers.”

Probably when he started driving, he encountered a few bad drivers. He peered into the driver’s seat and notice most of them were women. So he assumes and draws the conclusion that being female is a causal factor for bad driving. Overtime, it becomes his belief that this is the truth. Every time he encounters a bad driver, he will peer into the driver seat, and when he sees a female driver he will reinforce his belief, while subconsciously choosing to ignore the data when it is a male driver.

Investing mental models

As we first learn about the market, we have no experience or any rules to guide us to make our investment decisions. We grapple with the movement of prices and even the mechanism of making an order. A seasoned investor would have certain rules to guide him when he invests. The rules are derived from his belief about what makes a good investment. For example, based on his observation (selected data), a low P/E ratio is one of the important factors for a value buy. He will actively look out for stocks that have low P/E ratios. The stocks that earn money reinforce his belief while stocks that lose money will be considered as unlucky. Likewise for a technical trader, he will only choose to see when a particular chart pattern works and ignore the times when it failed.

While mental models are good as they help us shortcut our thinking process, they can handicap us if we adopt wrong beliefs. It will be even worse if a whole society embraces a wrong mental model. The deeper and more widespread the mental model, the more vulnerable it is. In my view (maybe I am a culprit of my own mental model), everyone believes that the safest asset in the world is United States Treasury bonds, and it will be disaster if one day the United States defaults.

 

By guest contributor Alvin Chow, who blogs at Big Fat Purse, a Singapore personal finance blog.

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