Many of us like to think we are natural born statisticians and savvy investors, but Daniel Kahneman proved that not even professional statisticians stand out here – given an sensible (but incorrect) number, our lazy system 1 will jump at it.
The above strip highlights this obstacle. While the comic makes the exaggerated point that an investor facing a 10 percent per year fee would nevertheless blindly proceed with investing, this parody is not far from the truth. Many mutual fund and hedge fund investors pay 2 percent per year or more on the amount invested— whether the value of their investment goes up or down!
There is an endless number of examples in real life on poor investment activities. For example you never get a second chance to make a first impression. Let’s say you see an ad for a mutual fund that says it returned 18% versus an ad for another fund with a 12%. Both ads have their percentage in big, bold letters so your first impression is that number. Now, which one are you likely to go for? What if you read the fine print and found that the 18% was just over the last year and the 12% was over the last decade? It might change the minds of a few of us, but most would still lean towards the 18%.
Or consider the fact that people with low deductibles and high premiums are often playing a losing game. Why? They are magnifying the odds of an accident when, in truth, the odds of an accident are very small. For example, a completely random selection of stocks will beat the market 50% of the time. So, if you have 1000 of these random selections, 500 of them will beat the market in a given year. The next year, 250 of those 500 will beat the market again. And in a third year, 125 of those will beat the market yet again. Look! 125 mutual funds just beat the market three years in a row! Shouldn’t we throw all of our cash into those? Not… really.
Another classic trap is the idea that people will tend to be more risky to avoid potential loss, but will be more conservative to lock in profits. Let’s say I gave you $1,000 and offered you either $500 more or the opportunity to flip a coin – if you win, you get $1,000 more but if you lose, you get nothing. Most people would choose the automatic $500. Now, let’s say I gave you $2,000 and said you either had to give me $500 of it back or we flip a coin – if you win, you keep all $2,000 but if you lose, you give me $1,000 of the money. In this case, most people would choose the coin flip. But the scenarios are actually identical. It’s actually this same central idea that convinces people to sell winning investments more readily than losing ones and also to make spending decisions based on how much money they’ve already spent.
Finally, not all dollars created equal. There are times where we treat a dollar with more value than at other times. Let’s say you were about to buy an item at Store A that cost $100, but you found out that the same exact item is being sold at Store B for $50 10 minutes away. Would you switch stores? Now, let’s change it a bit – let’s say the item at Store A cost $3,050, while the same exact item was on sale at Store B for $3,000 10 minutes away – would you go to the other store then? Most people would do it the first time, but not bother the second time. So is 10 minutes of your time worth $50 or not?
So when Robert Arnott said: “in investing, what is comfortable is rarely profitable”, maybe he was right on more points than intended – because what is comfortable is too often not adequately calculated!
Source: http://dilbert.com/strips/comic/2012-06-28/ and Why Smart People Make Big Money Mistakes