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Limitations Of Rational Thinking

>> Friday, December 18, 2009

People make choices in financial matters like insurance and investment based on knowledge and rational thinking. However, the decision making process is affected by values and emotions. By understanding our inner limitations, we can try to overcome them to make better decisions.


1. Emphasis on recent events
Rely more on information obtained more recently then on the overall big picture.

Implication on financial planning: Most people cannot see pass 5-10 years into the future. Hence, they often fail to plan for retirement until it is about 10 years away.

Implication on investing: Short term trends drive the emotions of investors, resulting in panic buying and selling. Current news also prevent investors from taking a long term position.

That is why visionary leaders have the exceptional ability to see 20, or even 50 years into the future and develop their plans based on that vision. A good local example is MM Lee.

2. Denial of risk
Failure to properly access the dangers or pitfalls.

Implication on financial planning: People may know the statistical odds of accidents happening but refuse to believe that these odds apply to them. Even to the extend that small probabilities are treated as non existent.

Implication on investing: There is a risk of losing the capital invested for most investments, hence the risk premium to earn a return. However, people often ignore this risk that it will not happen to them.

It is this exact denial that people still partake in gambling. Everyone is aware the odds of winning TOTO are one in a billion but they believe they might just be that one.

3. Control Bias
Underestimating risk involved in activities under own control and overestimating their own skill.

Implication on financial planning: Feeling that if they do some financial planning on their own, they have covered all aspects and are in full control. They do not need any extra help.

Implication on investing: They feel that they can pick stocks and trade like professionals without losing after learning some techniques. Others believe they can invest for better returns on their own if they were in control.

Everyone has some form of ego and self confidence. However, it is somethings good to be humble and learn from others. Although we think we know everything, there is still a lot of things we do not even know that we do not know yet.

4. Familiarity Bias
Place more emphasis on events where one is personally involved.

Implication on financial planning: The wake up call is often when something tragic happens to a close friend or relative that insurance planning suddenly becomes a top priority.

Implication on investing: Tend to only invest in more familiar things. Like investing only in the local stock market and fearing the international market. Or investing in stocks or property because people around you are also invested in them.

There is nothing like life experience to learn a lesson. When we witness a car accident, as compared to reading of an accident in the newspaper, we tend to drive on a little more cautiously (at least for a while after) for the former case.

5. Emphasis on absolutes
Prefer to view things in black or white.

Implication on financial planning: In insurance planning, this is best viewed as excess. We want the excess as low as possible, best if it is zero and we are even willing to pay a significantly higher premium for full coverage. (Comparatively for the same increase. i.e. 50% to 51% coverage versus 99% to 100% coverage)

Implication on investing: We look for guaranteed investments. If it is possibility of 1% loss, we will prefer to earn less interest for principle guarantee. That is why fixed deposits have such good business.

It is easier to understand things in absolutes, however, most of the things in this world is gray.

6. Internal yardstick
Things are not evaluated in a vacuum, it is always relative to something.

Implication on financial planning: The importance of financial planning for an individual is dependent on how important he think it is to achieve his financial goals.

Implication on investing: If wealth is inherited, it has a different value then if it is earned. Also losing money versus missing a confirmed opportunity to make money; Or making money versus a "missed" loss (Striking 4D or forgetting to buy and it did not open).

Each of us have a different yardstick and we need to understand our own so that we can better understand how we see the world.

In summary, Sun Tze said "Zhi Ji Zhi Bi, Bai Zhan Bai Sheng", in translation "know thyself, know thy enemy, and every war you fight shall be your victory".

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