Recently I read about an interesting experiment from the book “Thinking, Fast and Slow”. It is about the way our brain works and how to utilize more of your System 2 and constantly checking against the usual intuitions and stereotypes created by System 1. (System 1 is the part of the brain that is giving you “fast response” and System 2 is the part of the mind that gives you “slow and analytical response”. Think of these two as your answers to 1+1 and 14 x 3872. Answer to first question will come from System 1 and answer to the second, most likely, from System 2).
Less is More experiment:
Here is the interesting experiment:
The author created a fictitious lady called Linda. The basic description of Linda is as following:
Linda is thirty-one years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in antinuclear demonstrations.
The author presented to the participants of the experiments the following statements:
Linda is a teacher in elementary school.
Linda works in a bookstore and takes yoga classes. Linda is a psychiatric social worker. Linda is a member of the League of Women Voters. Linda is a bank-teller. Linda is an insurance salesperson. Linda is a bank-teller and is active in feminist movement.
The question is to rank the statements above in terms of likelihood to be true for Linda.
The result is very surprising that 89% of the respondents in the survey ranked “Linda is a bank-teller and is active in feminist movement” as a higher likelihood than the statement “Linda is a bank-teller”!
Anyone who studied basic statistics will recognize that this is a logical error: the likelihood of Linda being a feminist bank-teller is logically impossible to be higher than the likelihood of Linda is a bank-teller, because the former is a subset of the latter.
The author conducted several different versions of the study and it confirmed the findings: the participants, who were college students or graduate students who studied sophisticated statistics in the past, committed such logical error at rate of at least 75%!
What does this experiment tell us?
This is called Conjunction Fallacy, which people commit when they judge a conjunction of two events (in this case, bank-teller and feminist) to be more probably than one of the events (bank teller) in a direct comparison.
It also highlights that our System 2 (logical and analytical part of the brain) is not impressively alert. We certainly learned the Venn Diagrams in school. But many times in life, such knowledge did not get applied even all the relevant information was laid out right in front of us.
Remember, the laziness of System 2 is sometimes getting us into trouble in investing field. Many people got excited about a recognized pattern (in “Technical Analysis” or some other quantitative analysis area) and they decide to call certain correlation or stereotype as the golden rule, not aware of committing some very basic logic fallacies. In the fundamental investing world, lots of conversations were about “how great a brand is, or an CEO is, or a product is”, but people failed to wake up their System 2 to really work hard to derive a valuation before they commit to buying some stocks.
The easiness of committed a trade nowadays in online or mobile trading systems certainly is capitalizing this System 1 responses to generate a lot of activities (as a result they earn a fee for executing such impulsive decisions), and the lazy System 2 was left out without being consulted.
Just remember, always ask yourself, assuming your next vacation is entirely depending on it, before making a decision to invest. The price of “next vacation” will be high enough to wake up System 2 to avoid some basic logical errors.