Yes . . . but it doesn’t factor in our mental limitations

In a fascinating TED talk, Dan Gilbert considers why we make bad decisions. He starts by searching for a formula for making the right decision in every situation . . . and finds one! In 1738, Dutch intellectual Daniel Bernoulli proposed the following equation (as interpreted by Mr. Gilbert):

The expected value of any of our actions – that is, the goodness that we can count on getting – is the product of two simple things: the odds that this action will allow us to gain something, and the value of that gain to us.

That seems fairly straightforward. However, Mr. Gilbert goes on to demonstrate that we are very bad at estimating both the chances that we will succeed and the value to ourselves if we do succeed. We make a multitude of mental errors.

We equate the quickness with which things come to mind with a higher probability. When asked whether there are more four-letter English words with the letter ‘R’ in the first place or the third place, most people will guess, incorrectly, the first place. That is because we tend to remember words by their first letter, but words like ‘pare’ or ‘park’ come to our minds more slowly.

We underestimate the importance of things that are not newsworthy, remembering instead the headlines. We do not read, “Man Persistently Loses Lottery,” a vastly more common outcome than the freak chance of winning one.

Similarly, we are not good at assigning value, because we use comparison as a decision-making tool and that changes the value of things. Most of us would not pay $15 for a small bottle of water because we compare it to the price we are used to paying. But in a situation where we are terribly thirsty with no other options, $15 is suddenly less of a barrier. Marketing departments use this flaw in our reasoning process against us. When restaurant owners put an expensive dish on the menu, its function is largely to make the other items seem reasonably priced: the $28 salmon dish seems modest compared to the $60 lobster.

When considering an expenditure or investment, we should ask, “What else could I do with this money?” But we get caught up in comparisons to the past. In the opaque world of airfare pricing, you might be happy to buy an all inclusive vacation worth $3,000 if it is discounted for $2,600. However, if you find that same package discounted to $2,000, which then rises to $2,500 in the week it takes you to make your buying decision, you might refuse to buy it because you could have purchased it for $500 less the week before, even though it is still $100 less than the package you were originally prepared to buy.

Mr. Gilbert gives an amusing example of how our brain works. If you have two equivalent pieces of paper in your pocket – a $20 theatre ticket and a $20 bill – and you lose your ticket, you might refuse ‘to pay twice’ for the ticket by using the remaining $20 bill to purchase another one. If, however, you take two $20 bills with the intention of buying a ticket at the door, and you lose one on the way, you will probably still use the other to purchase a ticket. The former situation feels like having to pay $40 for something that had originally cost you $20, while the latter situation is interpreted as bad luck and doesn’t impact your decision to see the show.

It is surely indisputable that saving $100 is a good thing. If we are making a $300 purchase and that same item is on sale for $100 less twenty minutes drive away, we will almost certainly make the effort. However, a potential savings of $100 on a $3,000 or a $30,000 purchase might not seem worth the effort. Again, instead of thinking about the purchasing power of $100 and what else we could do with it, we are allowing its value to change based on a comparison. This fallacy hurts us even more in making very large purchases, like a home: where we might agonize about how to invest $100,000, we might make a snap decision to pay an additional $100,000 to win a bidding war on a $2 million house. The difference between $2 million and $2.1 million does not seem a worthy obstacle to getting what we want.

We understand our limitations in the physical world and build around them. Understanding our mental limitations would be a terrific starting point to achieving a better investment experience.  Or we could hire a professional to take on that decision-making process for us . . .

Daryn Form is a Senior Financial Advisor with Assante Capital Management Ltd. providing wealth management services to principals of family-owned and privately held companies. The information mentioned in this article is for general information only. Please contact him to discuss your particular circumstances prior to acting on the information above.  Assante Capital Management Ltd. is a member of the Canadian Investor Protection Fund and is registered with the Investment Industry Regulatory Organization of Canada.