Notes from our last Insights:
If I were to ask you what is more probable: Dying in a train accident or getting struck by lightning?…Most people would say train accident.
That’s because System 1 kicks in, pulls up memories of train accidents in the news and assumes that there is a higher probability of dying from a train accident than getting struck by lightning.
This System 1 action is referred to as the availability or familiarity heuristic.
But according to the National Center for Health Statistics, we have a higher chance of dying from a lightning strike than we do from a railway accident.
According to that same study, Americans are two and a half times more likely to die from a bee sting than from a dog attack.
Like bee stings, average market gains over long periods of time aren’t as headline grabbing as train crashes or market crashes, so they are not as prominent in our minds.
Investors are quick to succumb to System 1 thinking when we avoid “riskier” asset classes, especially when we have the impact of the great recession burned into the back of our minds.
By focusing all our attention on the potential for short-term fluctuations in performance, we ignore the fact that these “riskier” asset classes can be the ones that have the greatest long-term impact on portfolio growth.
The familiarity heuristic may not only cause us to avoid high-performing asset classes, it can also work against us by biasing us toward things we are familiar with. According to JP Morgan, people living on the West Coast tend to overweight the technology sector, while people living in Texas tend to overweight energy; and people in the Midwest tend to overweight industrials.
While it is wise to invest in asset classes where we have an edge, it is a statistical improbability that the entire universe of Texans has an edge in energy investments. And it’s equally improbable that the entire universe of Midwesterners has an edge in industrials. While System 1 might convince us all that we are “experts,” we can’t all have an edge. Not everyone is the “smartest person in the room.”
The irony of the familiarity heuristic is that it can cause us to avoid “riskier” asset classes on one side and cause us to overweight our portfolio on the other side, ultimately creating more potential hazard from a lack of diversification and concentration risk.
We are all swayed by our personal biases and deceptive thinking from time to time. The key to managing our thinking is to simply recognize that we are inclined to be biased. Rather than reacting to System 1 and our biases, we need to access System 2 and ask ourselves deeper questions.
Boiling it Down:
System 1 can do a pretty good job of keeping us alive in the jungle, but may not serve us as well when seeking to maximize our long-term wealth.
That’s where we need to recognize that we are inclined to be biased and our short-cutting heuristics may be hurting us. Tapping into the benefits of System 2’s slow thinking can help prevent us from making costly mistakes.