Unconscious factors influence how we invest

Imagine you are in the yogurt aisle at a grocery store. There are two products to choose from. One says “96.5% fat-free,” the other “3.5% fat.” Which do you choose? Although both are exactly the same product, a large majority will choose the first yogurt. This was demonstrated by an experiment carried out by researchers from the University of Glasgow and Unilever Research.

Behavioral science can provide one answer based on psychology: our decisions and actions are influenced by cognitive, i.e., perceptive processes. These are not always logical or rational. Instead, they are characterized by psychological behavioral tendencies and “heuristics,” i.e., internalized rules of thumb.

Every day we make tens of thousands of decisions – of both minor and major personal significance. If we had to consciously process all available information for every decision, we would be completely overwhelmed. “Heuristics” – personal and often subconscious rules of thumb – help us to make decisions based on our emotions and gut feelings. This is helpful in recurring, everyday situations, but can be deceptive in new ones or when making long-term decisions.

Irrational behavior does not just occur in the grocery store. We are confronted with bias even with the simple question: “heads or tails?” However you decide, you will only be right 50 percent of the time. But if you flip a coin three times in a row and it comes up heads each time, your gut feeling will tell you that tails is more likely the next time. However, the probability of either heads or tails is the same every time.

But what do such behavioral tendencies have to do with finances? Behavioral finance is a branch of behavioral economics that is dedicated to the heuristics and irrational thought processes of investors. This is because gut feeling and emotions alone are not a good basis for decision-making.

In the financial world, our decision-making processes are also subject to bias, although in theory we should make rational decisions that maximize our own benefit. So what exactly happens to our cognitive processes in moments like this?

Nobel laureate Daniel Kahneman and his colleague Amos Tversky have studied people’s cognitive thought processes for years to find an explanation for irrational behavior. They came to the following conclusion: people think in two systems.

System 1: thinking fast – fast, automatic, always active, emotional, stereotyping, unconscious

System 2: thinking slow – slow, tiring, rarely active, logical, calculating, conscious

In his book “Thinking Fast and Slow,” Kahneman defines his model by dividing our thought processes into two types: system 1 is fast, subconscious thinking, whereas system 2 is slow, conscious or rational thinking. He also identifies drivers – so-called biases and heuristics – that can influence our actions in system 1. The result: our cognitive thinking and decision-making processes are often distorted when system 1 is at work.

As investors, it is best to think using system 2. However, this is not so easy and takes a lot of effort. This is why we are not always able to deliberately switch from subconscious thinking to rational thinking. Instead, we need to be aware of our psychological behavioral tendencies and heuristics so that we can control them. This is important, for example, in order to process all the information available to us before making investment decisions. Financial advice can help here and provide a push in the right direction.

To avoid biased thinking and decision-making processes when investing, you should become aware of which biases and heuristics influence you in your everyday financial life. Behavioral finance theories that attempt to describe and explain different types of biases can help here.

Biases such as framing, i.e., the selective focus on only some of the facts, such as “fat-free,” can lead us to make irrational decisions when buying yogurt, for example. The next time you make a purchase, pay attention not only to what is written on the product, but also to whether you have really understood all the information.

Further examples from the financial world and information on biases and heuristics in behavioral finance can be found in the following articles.