First, a quick quiz
Note your score and read on…
Biases and Investing
One of the foundational principles of this site is that as much as traditional economics likes to think of human beings as rational beings who make decisions based on clear and unchanging criteria, we are actually incredibly flawed in how we perceive and make decisions. Our brains are prone to taking easy shortcuts to avoid expending the energy required to process information objectively before making each decision. And so it is, in investing.
The Cognitive Reflection Test
Over the years, while several studies have made it clear that behavioral biases exist, another body of work has sprung up around the idea that while all of us have these biases, susceptibility to them varies by individual. Being able to identify and measure the extent of this susceptibility would be a powerful tool in business (to identify customer preferences) and when hiring (to predict decision-making). In 2005, psychologist Shane Frederick at Yale University designed the quiz you did at the start of this post. It is called the ‘Cognitive Reflection Test’. This test was used as the basis for a paper titled ‘Cognitive Abilities and Behavioral Biases’ by Joerg Oechssler, Andreas Roider and Patrick W. Schmitz of the Economics Department at the University of Heidelberg. They administered the CRT to 1,250 subjects.
Here’s what they found:
The Cognitive Reflection Test (CRT) introduced by Frederick (2005) is a quick and simple three-item test, and Frederick (2005) documents that the CRT compares very favorably (in terms of the relationship between test scores and observed behavior) to substantially more complex personality tests. The CRT differentiates between more impulsive and more reflective decision-makers. To achieve this, each of the three questions of the CRT has a seemingly intuitive (but incorrect) answer that springs quickly to mind, and the overwhelming majority of subjects indeed provides either the impulsive or the correct response (more than 90% of subjects in all three questions). The questions of the CRT are not difficult in the sense that the correct solution is easily understood when explained to subjects. Moreover, if a solution springs to mind it is easy for subjects to verify whether their response is indeed correct. However, arriving at the correct answer may require overcoming the initial, impulsive response
This means, the fewer questions answered correctly in the 3 question CRT, the more impulsive your style of decision-making. Conversely, the high scorers on this test can be considered as more reflective decision-makers.
The results for the “general” population were in line with what Frederick had found with MIT and Princeton students that were part of his test. On average, respondents got 2.05 questions of the three right.
Connecting decision-making style with behavioral biases
Having identified the “low” and “high” CRT individuals, the researchers then ran the respondents through a series of questions aimed at identifying susceptibility to various biases and its link to their CRT scores. Some of the findings were fascinating:
1. Impulsive decision-makers were less patient than their reflective counterparts
When offered an immediate payment for their participation versus being paid 1 month later, with 10% interest, the low-CRTs picked the immediate payment more than the high-CRTs did
2. Impulsive decision-makers were more likely to commit conjunction fallacy than the reflective group
This is the result of a classic test from a paper by the Amos Tversky and Daniel Kahnemann, called ‘The Linda Problem’. Consider this:
Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations.
Which of the two statements is more likely to be true:
- Linda is a bank teller
- Linda is a bank teller and is active in the feminist movement
Mathematically, it is impossible for statement 2 to be likelier than statement 1, but over 62% of the low-CRT group picked #2 compared to 38% of the high-CRT group
3. Impulsive decision-makers are likelier to be prone to the conservatism bias
Imagine two urns A and B, A contains 3 blue and 7 red balls while B contains 7 blue and 3 red balls. Balls are drawn randomly from one of the urns, and replaced after each draw. 12 random draws result in 8 red and 4 blue balls. What is the probability that the urn used was A?
The correct answer is 0.97. However, we’re less able to factor in the information of the results of the 12 draws and estimate this lower. The low-CRT group estimated 0.59 while the high-CRT group estimated 0.69.
4. Reflective decision-makers were (marginally) more prone to anchoring than impulsive decision-makers
Anchoring refers to our tendency to rely heavily on the first piece of information that comes our way to make subsequent decisions. Turns out there wasn’t a significant difference in the two groups, but the high-CRT folks showed more susceptibility
5. Impulsive decision-makers tend to be overconfident in their decisions
When asked how many questions they thought they got right on the CRT, nearly 63% of high-CRT respondents got it right versus only 10% of the low-CRT group. This makes sense considering the impulsive group tended to judge their intuitive (and in this case wrong) answers as correct.
What your decision-making style means to your bias susceptibility
All of us are susceptible to behavioral biases mentioned here, but the more impulsive among us have to be more vigilant about the possibility of committing these errors in judgement which could in combination result in some seriously poor decision-making
Link to the full paper ‘Cognitive Abilities and Behavioral Biases‘