Thinking Fast and Slow
TL;DR: Learn about cognitive biases.
About 6 years ago when I did my first internship in quantitative finance, one of the first books recommended to me was Thinking Fast and Slow by Kahneman.
It introduces many cognitive biases in most people, put many times in the context of economics.
For example, the concept of anchoring. This is the idea that hearing numbers before making an opinion can bias your perception of a “fair value”. The amazing thing is that the numbers you hear could be completely unrelated to the numbers you are estimating. There have been experiments where you can ask a room of people the last two digits of their phone number, and then asking how old Gandhi (for example) was at his time of passing. The phone numbers and the estimates end up being correlated! This has obvious ramifications in investing, where you have to be mindful of your recent conversations and thoughts when pricing financial securities.
Here’s another one. The “Possibility effect”. This is the concept that drives people to buy lottery tickets, despite this (usually) being a terrible investment. People assign a ton of value in bringing some good thing from being impossible to slightly possible, and unjustly so. For example, for most people, their gut would tell them that they may want to pay $2 for that Powerball ticket where their chances at the jackpot are roughly 1 in 300 million. How much would you pay for the ticket if the chances became 1 in a million? These same people might say something like $3, or $5, or maybe $20. However, the fair value of the lottery ticket has now become (on average) roughly $480! It went from being a bad investment to a great investment, yet most people would not be able to grasp the difference.
Here’s one more. Consistent and plausible stories are overweighted in probability/meaning. For example, when you interview candidates for a job you could have a list of traits that you obviously want and test for; every employer does this. With these metrics you could possibly see huge differences between different candidates. This gives employers a lot of confidence in their choices of hires. However, it’s pretty usual to find a conversion to the mean between all hired employees – after some time most employees turn out to be closer in productivity than the initially estimated difference. However, this somehow doesn’t deter the bias in employers that they are great in interview evaluation. This is quite the cognitive illusion.
There’s many many more like this in Thinking Fast and Slow. This book is one of my go-to favorite books to reference, and has pointed out many concepts to learn in becoming a rational investor.
Happy Reading,
TheJKW
P.S. Here’s a link for convenience: https://amzn.to/2YjtRJ6. As an Amazon Associate I earn from qualifying purchases. However, I wouldn’t put this here if I didn’t fully believe in its value. It’s pretty cheap compared to its value – I got myself a paperback.