Anatomy of a Decision
By Sara López
Times like the one we are living through, marked by mistrust and uncertainty, have various effects on society in general and on investors in particular. One of the emotions that best describes the current panorama is, without a doubt, fear. Fear can be understood in many ways; we can interpret it as an intense and unpleasant sensation when faced with the perception of a real or imaginary danger; as an alert response of the nervous system to a potentially threatening stimulus or even as an attitude of avoidance, rejection and flight in the face of the unknown.
The philosopher Jose Antonio Marina affirms that fear produces a triple narrowing of consciousness; corporal, psychological and behavioral. Any of these alterations of consciousness can affect the investor’s behavior, producing effects that can transform his perception of reality, the certainty of knowledge and acquired experience and, therefore, lead to irrational decision making.
Daniel Kahneman in his work Thinking, Fast and Slow distinguishes two systems of thinking, fast thinking and slow thinking. System 1 constantly makes suggestions to system 2 in the form of impressions, intuitions, intentions and sensations. If it meets with the approval of system 2, impressions and intuitions become beliefs and impulses become voluntary actions. Only when system 1 encounters some difficulty, it turns to system 2 to suggest a more detailed and precise procedure that can solve the problem. This division of labor minimizes effort and optimizes execution. Thus, intuition and reasoning would be the two modes of thinking.
However, we should not ignore the dichotomy between reason and emotion. Human behavior rarely responds to the ideal of the fully rational agent. Our decisions are deeply influenced by the quick, intuitive impulses of system 1 and the laziness of system 2. Therefore, when fear comes into play, this delicate balance is disrupted and behavioral transformations are generated that are identified as biases. Behavioral biases can be understood as mental shortcuts or cognitive “tricks” that we use to simplify decision-making in complex or uncertain contexts. Behavioral economics studies precisely how these mechanisms influence the perception of reality and states of consciousness, often leading individuals and even experienced investors to make decisions that are far from rational.
The main cognitive biases in investment decision making are:
– Confirmation: interpretation of already existing information or search for a new one to corroborate previous convictions or ideas.
– Anchoring: predisposition to give more weight to information obtained in the first place than to new information that contradicts it (the associated risks are not considered).
– Authority: tendency to overestimate the opinions of certain people simply because of who they are and without subjecting them to prior judgment.
– Social proof: tendency to imitate the actions of others in the belief that one is adopting the correct behavior.
– Hyperbolic discounting: propensity to choose smaller, more immediate rewards over larger, more distant rewards (immediate gratification).
– Loss aversion: tendency to consider losses as outweighing gains. This bias can also lead to the so-called myopia effect, which is particularly detrimental to long-term investors, who continually evaluate the value of their portfolio and overreact to news and events occurring in the short term.
Therefore, in market correction contexts, such as the one we are currently going through, the figure of the financial advisor acquires a crucial relevance. These falls not only affect the value of investments, but also trigger intense emotional responses in investors, such as fear, anxiety and the urge to make impulsive decisions. These emotional states trigger behavioral biases that can lead to the cancellation of well-structured strategies. In this type of situation, the financial advisor not only plays a technical role, but also an emotional and behavioral one, acting as a mitigator against hasty decisions and helping to dissuade this fear by keeping the portfolio adjusted to the risk profile of each client.