Illogical instinct

In the first part of a new series on investor psychology, learn why you should not rely on intuition to solve financial issues.

Kamya Jaiswal        Print Edition: July, 2010

A bat and a ball cost Rs 1.10. The bat costs a rupee more than the ball. What is the cost of the ball?

It takes five machines five minutes to make five widgets. How long will it take 100 machines to make 100 widgets?

There is a patch of lilies in a lake that doubles in size every day. If it takes 48 days for the patch to cover the lake, how long does it take to cover half the lake?

Have you answered 10 paise, 100 minutes and 24 days? These are the wrong answers, but take heart, because you belong to the majority. More than 80 per cent of the nearly 3,500 people, who took this test in eight universities across the US, came up with responses belonging to this set. Unfortunately, the majority can be wrong sometimes. Write down the equations for each numerical and you will discover why.

Even fifth graders can solve these problems, so why couldn't you? The reason is the fraction of a second you took to answer each question. In such an infinitesimal time span, the brain's logical section is not activated and it can't process information. Your answers were instinctive and, therefore, wrong. If you had thought about them before answering, the errors would be obvious.

Shane Frederick, professor at the Massachusetts Institute of Technology, US, who formulated these questions, does not claim them to be a part of an intelligence test. The questions only measure your cognitive reflection skills, that is, the ability to resist considering your first impulse as the answer. Simply put, they test whether you are patient enough to make a judgement on the basis of facts, instead of intuition.

This is why, if you belong to the rare club of people who got all answers right, you probably took a little longer to come up with the solutions. Laudably, you have trained your mind to approach a problem logically.

Frederick's test challenges one of the mainstays of behavioural finance, the loss aversion theory. According to this, people would rather lose less than gain more or gain a small sum than lose out on a big amount. However, Frederick discovered this is not true for everyone. Those who score well in the cognitive reflection test are more likely to choose, say, a 15 per cent chance of winning Rs 10 lakh than an immediate gift of Rs 5,000. Similarly, those who get the answers wrong would be wont to opting for Rs 5,000 because they are motivated by instant gratification and do not allow the mind to weigh the huge difference in the value of gains.

The lesson is clear—don't follow your hunches blindly. Celebrity investors, who write books on how their instincts were proved right, do not tell you about the extensive research they conducted on stocks. Neither do they talk about the numerous 'hunches' that they discarded. Curbing impulses is not easy. When the tumultuous Greek economy pushed down the global stock markets, didn't you want to bail out? This reaction would have been triggered by panic. However, if you had acted on instinct and actually exited, it would have been an over-reaction to a market correction.

So, give your mind time to think before you make a financial choice. Chances are, it will opt for the right balance of risk and reward. However, it is unlikely to do so if you still haven't figured out that the answers to the three questions are five paise, five minutes and 47 days, respectively. In such a case, you need to call your maths teacher. Now.

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