The role of emotions in our decision making and investing behavior

How can Emotions lead us to irrational investment decisions?

Emotion vs Reason

The tug of war between logic and emotion is as ancient as the human species itself. It is what separates us from other mammals. When we were still in caves, the emotional brain was responsible for quickly looking at the surroundings and identifying whether anything interesting (prey) is available. Once it has identified something interesting, it will decide to pursue the target and use the logical brain to rationalize the decision and go for the kill.

Similarly, in any product or website design, the emotional brain will help you immediately identify patterns and areas in the exciting design — like adding to cart button, product image, a search bar to find information, etc. Once the exciting regions are identified, it directs the logical brain to go forward with the next steps of buying the product, clicking on the image, or typing some keywords in the search box.

System A, The downstairs brain is the part of our brain that makes us act without thinking. It is all about the association: it is automatic, regular, unconscious, and primarily emotional. It has to do this quickly for survival purposes. It is fast, sure, but it is fast precisely because it is intuitive and easy. Its activity includes the innate mental activities that we are born with, such as a preparedness to perceive the world around us, recognize objects, orient attention, avoid losses — and fear Lizard! Other mental activities become fast and automatic through prolonged practice.

System B, The upstairs, rational brain, while structurally all there, is much slower. This part of the brain is highly sophisticated and responsible for problem-solving, logical thinking, planning and decision making, organization, and self-control. This part of the system is the one that requires effort. It requires attention and deliberate thought. It’s what powers your strategic thinking, your long-term planning. Its activity is activated when we do something that does not come naturally and requires conscious mental exertion.

In conclusion, The brain processes information to make decisions using either the logical and rational system or the quick and emotional system.

The rational system is better for significant decisions; these generally should not be rushed. However, the emotional system can be lifesaving when time is of the essence, and it can be much more efficient when based on developed experience and expertise.

Kahneman’s System that Influences Your Decisions

Decision-making is perceived as the competition between an emotional system that is automatic or reflexive but prone to error and a reasoning system that is slow but logical. However, when cognitive capacity is weak, the time to take the decision is less, or there is too much unknown information or too much uncertainty. Emotion may overwhelm reason and become more salient in our decision-making.

To summarize, we can say that emotions underpin many more decisions than simply those based on strong feelings. Our brain has found a mental shortcut that allows us to solve problems and make judgments quickly and efficiently using system A.

These strategies shorten decision-making time and allow people to function without constantly thinking(Using system B) about their next course of action. These shortcuts are called Heuristics, and they are helpful in many situations, but they can also lead to cognitive biases.

Heuristics play essential roles in problem-solving and decision-making, as we often turn to these mental shortcuts when we need a quick solution.

How Heuristics Can Lead to Bias

A cognitive bias is a systematic error in thinking that occurs when we process and interpret information that affects decisions and judgments.

Our brain is powerful but subject to limitations. Cognitive biases occur when we use our system A, Bias is often a result of your brain’s attempt to simplify information processing. They often work as thumb rules that help us make sense of the world around us and reach decisions quickly. It can be vital if we are facing a threatening situation.

For example, if we are walking down a dark alley and spot a dark shadow that seems to be following us, our biases can lead us to assume that it is a robber or a ghost and that we need to exit the alley as fast as possible. The dark shadow could be caused by a flag waving in the breeze, but relying on mental shortcuts can often get us out of the way of danger in situations where decisions need to be made quickly.

Heuristics and Investing

Nowadays, professionals in any industry may find themselves working with mounds of complex data to solve a problem. Heuristic methods these shortcuts can be used to help with data complexity, given limited time and resources.

These shortcuts facilitate timely decisions. We use intuitive guesswork, trial and error, the elimination process, formulas, and historical data evaluation to solve a problem in the financial industry. These methods make decision-making more straightforward, simpler, and faster through heuristics and good-enough calculations.

However, trade-offs are using these shortcuts that render the approach vulnerable to bias and errors in judgment. The final decision may not be the ideal solution. The decision could be inaccurate, and the data selected might be inadequate, leading to an erroneous solution to a problem.

For example, popular heuristics in decision-making is called representativeness heuristics. Representativeness is the tendency to use past events or traits representing or similar to the current situation. Say, for example, ABC paints operations in India, and its stock price increased. An analyst identified India as a profitable venture for all the paint industry. Therefore, when XYZ announced its plan to explore the Indian market the following year, the analyst wasted no time giving XYZ a “buy” recommendation.

Although his approach saved reviewing data for XYZ, it may not have been the best decision. XYZ may not have colors that are appealing to Indian consumers, which research would have revealed.