Psychologists Kahneman and Tversky have shown that people, even experienced researchers, make poor decisions when faced with uncertainty. In a research paper, Judgement Under Uncertainty, Kahneman and Tversky highlighted three decision making processes that people use to assess probabilities or make estimations:
1. representativeness;
2. availability; and
3. adjustment and anchoring.
According to Kahneman and Tversky (1974), “A better understanding of these heuristics and of the biases to which they lead could improve judgments and decisions in situations of uncertainty.”
Applying this to the current crisis
Markets have moved with such speed and velocity since the beginning of the coronavirus outbreak it has been difficult to accurately ‘anchor’ risks. It’s almost impossible to adjust with so much information and misinformation being circulated. We are making decisions based on small samples. Many adjectives and considerable emotive language has been used to describe the outbreak and its impact.
It’s important to look past the positive and negative commentary and concentrate on your long term goals. Assess risks, understand the data, without emotion or haste. Often we are ignoring probabilities relevant to our decision. The chance of rate cuts, which impacts prices, is changing hourly. In markets, unpredictability is the only constant. Successful long-term investors survive short-term falls by sticking to investment principles that have withstood the tests of time. For portfolios, this may include better diversification. For equities, investing in profitable companies with strong balance sheets and stable earnings has historically given resilience to portfolios.
Kahneman and Tversky’s lifelong passion was to understand why people do not detect the biases and flaws of their own judgements. They proved we are poor decision-makers when faced with uncertainty. An understanding of these can help investors better assess periods of uncertainty and thus lead to better decisions in uncertain environments.
Here is the link to the full article.