Nudging in Investing

Dear readers, upon reading the book called Nudge, I feel very exciting for knowing that what I have been talking about earlier were already systematically studied and recognized. Therefore, as much as you may enjoy the amusing language or vivid examples in the book, let me try to keep up with it by linking some of the key concepts in there to value-investing.

Previously, I talked about my experiences of selling my losing insurance stock to purchase the pig-breeding stock. In that scenario, I felt reluctant to do what I calculated. I attributed that force of reluctance to my strong intuition, humanistic inclinations, or simply just greedy. It is something that I cannot explain where it comes from but somehow well established in terms of its legitimacy. The book refers to this phenomenon as the Automatic System whereas all the ‘unintuitive’ statistical conclusions I made are classified as Reflective System. That explains my split personalities. What a relief! As the book goes on discussing common biases, a couple of terms got my attention. Loss averse is introduced as a kind of cognitive nudge that pressures people to not make changes, even if the changes are beneficial for them. This is very familiar to me as I face this situation very frequently as my stock research goes on. It is always hard to sell your stocks that are suffering a loss. It is like how protective we are of our failures. We want to wait and see if the turning point is right around the corner. For us to admit our mistakes and move on, the alternative must be appealing enough, at least twice the rewards comparing to the losses according to the experiment mentioned in the book. Well, there is simply no such thing in the market to spoil us, so we can see how this particular bias could cost us many great opportunities.

There are many other biases. For example, the availability heuristic happens when you form your judgment based on previous experiences. If you are an experienced trader who lived through all the financial crises, you will be more cautious and vigilant when it comes to decision-making. It gives you a systematic error that defines the market as riskier than it really is. There is also the representativeness heuristic where we perceive something according to the stereotype of that category. This concept is very easy to understand but hard to avoid because ultimately this is the theoretical support for your Automatic System. For instance, when a stock hits rock bottom, we tend to think that this is a great position for buy-in because stocks always bounce back after a great recess. Anyone who says this out loud would realize how ridiculous it is but somehow loads of people are still doing it.

Although the book reveals certain phenomena similar to my discovery, it does give me direction to further elaborate my investigation. What I did wrong is that I think of intuition or those humanistic drives as something that is unexplainable, abstruse, and illogical. I tried to influence people’s trading decisions by reinforcing the strength of the logical argument, the Reflective System. Now, I realize that in order to truly reshape investors’ mentality, we should start with the interpretation of their biases. Only could they do the right thing if they know why they are wrong in the first place. A little extra parenting lesson for you all…