The man behind Warren Buffet

I fully believe that the secret to success lies in the mental habits and in the recognition of cognitive biases that we all have as people. If you have poor mental habits, you likely won’t be maximizing your talents, and vice versa. Learning to recognize and control these mental habits allows you to control how you react and respond to events and situations. In other words, you choose how to respond rather than having something else choose for you. In order to have to power to choose how to respond, you first need to know that there are forces in your mind that you were naturally born with through years of evolution. Recognize these forces, these mental habits, these cognitive biases and take control of your life.

Learn “mind control”. Not over others, but over yourself. Learn how in this article.

Meet Charlie Munger

“We recognized early on that very smart people do very dumb things, and we wanted to know why and who, so we could avoid them” – Charlie Munger

Charlie Munger is undoubtedly a very smart man. At the age of 93, one has to think whether there is a correlation between knowledge and age. While an interesting question, that’s not the topic of this post. What we’re going to cover here are the 25 Cognitive Biases in which Charlie originally laid out in his speech The Psychology of Human Misjudgement.

The point behind writing this is that a lot of people seem to just make flat-out stupid decisions for what seems to be no good reason. It’s these 25 Cognitive Biases that are the root cause behind those illogical decisions.

 

These Are Mental Habits You Can Change

Now you may think to yourself “Oh my gosh, I’m screwed! These are the reason I can’t do anything right”.

There’s hope. These are just mental habits.

Some of them are good habits, and some aren’t so good. Habits, that through awareness and practice, can be overcome. It won’t be easy. You can thank your System 2 for that, but it can be done. More importantly, anyone and everyone can overcome these mental habits.

By the way, I’ve included both practical examples and explanations that incorporate the context of trading. Enjoy, and let me know what you think in the comments!

Cognitive Biases 1-5

1. Reward / Punishment Bias

What Is It?

Charlie makes the point that this is the most powerful of all the cognitive biases, or tendencies as he likes to call them. This is one of the fundamental influences of all human behavior. People tend to make choices based on what they will gain, or based on what they might avoid.

Think of when you were a kid. Looking back, you probably did a lot of things to please your parents so that you could go out with your friends. You might have also done things out of the fear that you might be grounded.

Takeaways

This principle still applies to full-grown adults. When was the last time you were at work and you really didn’t want to get started on that project? The odds are that you have felt this way pretty recently.

What did you do? You buckled up and got that project done!

This is because you feared punishment from your boss. Or it could have been that you’re an overachiever, and want to get ahead so you can be rewarded with a promotion.

Application to Trading

The tendency towards reward is why many people get into trading in the first place. The fact is that the potential reward that can come from trading is quite enticing.

It’s the fear of punishment (read: “losing money”) that causes us to keep our risk in check, and hopefully limit the dumb mistakes that we all make.

Fear and greed, right?

2. Liking / Loving Bias

What Is It?

Charlie describes this tendency/bias as the reason why we tend to overlook the faults of people/companies/things we like.

Remember the first time you started dating your significant other? They were awesome (and they still are)! But in the honeymoon period, they could do no wrong.

After that honeymoon period ended, you started noticing (natural and human) things in your significant other that kind of annoy you (like a lot). The honeymoon period has the Liking/Loving Bias written all over it.

Takeaways

Be careful of the clouded judgment that comes along with a new love or a close friend. You will naturally want to bias yourself towards these people.

I’m not saying don’t bias yourself towards these people. I’m saying know that there’s always a storm right around the corner and that you shouldn’t forget it.

Application to Trading

We tend to ignore our losers when we’re winning. Big mistake. The elation and excitement when you’re making money and trading well should not cloud your judgment.

Don’t forget that losing is a part of the game. Your biggest loses typically tend to follow periods of intense joy and happiness. Yes, or yes? Yes.

3. Disliking / Hating Bias

What Is It?

Have you ever been around those people whom you just hate? Like they don’t just annoy you. For whatever reason it may be, you can’t stand to be around them, but you have to be around them because they’re a co-worker or a friend-of-a-friend who’s just always around.

Think of those times where you’ve had to engage in conversation with these people. No matter how good of an argument or position they pose, you just can’t accept it because it’s… well them who’s proposing it. That, my friends, is the Disliking/Hating Bias.

Takeaways

At its essence, the Disliking/Hating Bias is the tendency to overlook good ideas, or good aspects of a certain thing, because you don’t like the person. It’s also called ad hominem, a logical fallacy.

Application to Trading

Don’t overlook someone’s opinion just because you don’t like the person. You might be working at an investment or a trading firm where you have to interact with colleagues to make collective decisions.

Ignoring other people’s perspectives because you don’t like the person is not only dumb but deadly to the firm’s overall success.

Why do you think Ray Dalio runs Bridgewater with such openness to ideas?

4. Doubt Avoidance Bias

What Is It?

Ready, Fire, Aim is an apt saying for this Bias. How many times have you made a hasty decision that wasn’t quite the best (actually it was terrible) all because you didn’t want to seem ignorant?

Yeah, you can thank this Doubt Avoidance Bias as the behavioral habit behind your decision.

Charlie describes the Doubt Avoidance Bias as the tendency to make ill-informed decisions, because we want to remove the feeling of doubt that we are experiencing.

In other words, feeling doubtful isn’t a great feeling. So we have a tendency as humans to act on things in an effort to remove the feeling of doubt, even though those actions might not be what’s best.

Takeaways

“Don’t be hasty”, Treebeard said to the Fellowship.

There’s a lesson in that. Don’t act because of your emotions when you have incomplete information. Actually, very rarely should you even act on your emotions.

Application to Trading

The form of this Bias tends to show through in people who overtrade. Think about it. When you’re overtrading, you’re not seeing things clearly. You have no idea what’s actually going on.

So in attempt to remove that doubt of future events, you start clicking the button hoping that something sticks. We’ve all been there. The way to overcome this is to take a step back from the market when you are doubtful.

Remember, trading is a game but it’s one of the most serious games you will ever play. Don’t risk it when you don’t have to.

5. Inconsistency Bias

What Is It?

This one is brutal. This is why we tend to maintain our habits (good, or bad) in spite of our best efforts to change them. If you can understand and recognize this Cognitive Bias in yourself, then altering the other 24 Biases will become much easier.

Robert Cialdini, in his book Influence, describes this as Commitment & Consistency. Charlie is a fan of Cialdini’s book, so he no doubt borrowed this idea.

Have you ever wondered why a romantic couple, who just flat-out aren’t meant to be together, stay together? Either the man is emotionally or physically abusive, or the woman is a gold digger? Have you ever noticed how this couple might break up from time to time but in spite of that, the couple always seems to get back together?

You see, we all have this thing in us that wants homeostasis. We want things to stay status quo. We don’t like change. That is the Inconsistency Bias, or Commitment & Consistency Bias, whichever way you want to phrase it.

Takeaways

The reason that it’s so easy to fall into the trap of this Bias is because your mind is subconsciously conserving energy.

Your body and mind only have so much energy to do things each day. The more that your mind can put things on autopilot and not worry about them, the easier it is for your mind to function.

Think about it, if you had to consciously think about the what and the why of everything that you’re doing, that would be pretty exhausting. Moreover, we tend to align our actions with our belief system and self-image.

So to try to go against our natural habits is to, in a way, go against the core of who we are and what we believe in.

For stubborn people (which we all are to some degree), this can be even more difficult to overcome. For more on this particular topic, I recommend checking out Cialdini’s book and Thinking Fast, and Slow by Daniel Kahneman

Application to Trading

When you’re in a losing position and you know you’re wrong, get the hell out of it! Don’t succumb to the need to be right, or your sub-conscious commitment towards staying consistent with your position.

I mean you do you. It’s your account. Just be aware of the root cause of your actions.

Cognitive Biases 6-10

6. Curiosity Bias

What is it?

This Bias is much less dark than the other Biases, but still important to be cognizant of. The Curiosity Bias is the tendency we have as humans that allows us to advance as a species as a whole. For instance, take a look at monkeys. Are they creating self-driving cars or self-landing rockets? Nope.

This Bias is the tendency we have to naturally be curious about things.

Takeaways

Be curious. Stay curious. Never stop learning.

Application to Trading

Always be learning, and willing to look at things differently.

7. Kantian Fairness Bias

What is it?

Kantian Fairness Bias is what allows most societies to function, with the exception of the law and whatnot. Another way of thinking about Kantian Fairness is to liken it to the “Golden Rule”. Have you ever noticed that sometimes a stranger is kind to you for no reason at all?

The Kantian Fairness tendency is why a total stranger lets you cut in front of them when you’re in line at the grocery store with 1 item (To all those people who don’t do this: Screw you. Just sayin’…).

Moreover, Kantian Fairness is the collective set of customs and traits that are deemed socially acceptable in the present moment of history. This shared mindset has been ingrained in us from the ancient times of our hunter/gatherer ancestors.

It’s what allowed them to function in tribes. The hunters hunted, and the gatherers gathered. Without the two functions, survival was much more complicated than it would be otherwise.

Takeaways

It’s important to be aware of this Bias people have, because it allows you to not piss off the wrong person. I’m not saying you should be a fair person for the sake of your own self-interest, but I kind of am.

Application to Trading

The application to trading here is that even though trading, for the most part, is an isolated activity, it’s still important to learn and interact with other people in the space.

No man is an island.

Even though it may seem that way, it’s not. Paul Tudor Jones, Ray Dalio, and Stanley Druckenmiller did not become the great icons of the industry that they are by operating in a vacuum, void of any other person.

For traders, the takeaway is to be open to others ideas.

8. Envy / Jealousy Bias

I’m sure you can already guess this one.

What is it?

You know what envy is. You know what jealousy is. You’ve felt them both, and I have felt them both. It could be easy to mistake this as a tendency towards greed, and glutton.

However, Charlie in his book Poor Charlie’s Almanack cites his partner Warren Buffett as saying, “It’s not greed that drives the world, but envy”. Interesting nuance there.

Takeaways

So why is this important to be aware of? Be aware of why you’re doing what you’re doing. Is it out of your own desire, or is it out of envy or jealousy of someone else?

I can almost guarantee you that if you do succeed at something, but your motivation was wrought with envy and jealousy, the taste of success won’t be quite as sweet than if the success were based on your own personal desires.

Application to Trading

Now I said that you should be open to collaboration, and learning from other traders. Don’t be an island.

Don’t become envious that other traders are making more money than you are. You will make dumb decisions in your own account that will more often than not make you lose money.

Walk your path. You will make more money and be able to trade larger size in time if you stay true to bettering yourself.

9. Reciprocation Bias

What is it?

Reciprocation Bias is another tendency that I’m sure Charlie borrowed from Robert Cialdini’s Influence. I’d bet on it.

The reciprocation bias is the tendency that we have to want to repay others who have done good to us. This tendency can be abused by the wrong people, so watch out.

I could get into a multitude of examples here, but I’ll keep it short and to the point. Going out to lunch with a friend is a good example. When one friend pays the bill, it’s only natural that you reciprocate this the next time you both go out. You would pay next time.

When a buddy gives you a ride to the airport for free (and you didn’t have to convince your friend), you naturally feel a need to repay your friend in some way. That feeling of needing to repay them is the Reciprocation Bias. Like I said, this can be abused.

I could just say the word “Politician” and leave it at that.

Some people are Machiavellian psychopaths and know how to use this against you. Some people will give, give, give, and once they’ve felt that you notice they’ve given a lot, and you haven’t reciprocated in return… they go in for the kill.

Takeaways

Be aware of the power of the Reciprocation Bias.

It can be used effectively to form mutually beneficial relationships and to strengthen existing ones. The Reciprocation Bias can also be used to screw you over if you aren’t aware of the what the other person may be doing to you.

Take heed. You’ve been warned.

Application to Trading

There isn’t much to take away here for small-time traders and investors. However, if you are at a bigger firm, the Reciprocation Bias can be used very effectively when building relationships with liquidity providers and other brokers.

10. Association Bias

What is it?

The Association Bias is pretty neat and explains why our mind can sometimes deceive us even if we think we’re being logical. The Bias is centered around (you guessed it) association. For those of you somewhat familiar with psychology you could compare it to anchoring.

Speaking of anchoring, here’s a really funny video that is an example of anchoring…

Charlie gives the example that things with higher prices tend to be perceived as higher value and have better overall quality, even if the item in question isn’t that great. People tend to associate higher prices with higher quality, and thus the mental bridge between the two is created.

This Bias also explains why people higher on the socio-economic ladder tend to associate those on levels below them with a different set of characteristics. I’m not saying that’s great, or noble, I’m just describing the Bias here.

Another example that Charlie provides is hearing military bands play would have someone associate that music with military service. You could look at Association Bias as finding things that are correlated with one another.

The recognition of this human Bias is the foundation of our legal system’s “Innocent, until proven guilty” mode of operation.

It’s easy to assume that because some hooligan who hangs around drug dealers would be more likely to be guilty of dealing drugs himself if he was ever accused of doing so.

However, to convict such a person on the basis of hearsay and association, rather than hard evidence, would be to fall into the trap of the Association Bias.

Ever heard of “guilty by association”? Think twice before you judge someone without actual evidence to support your opinion.

Takeaways

The mistake in basing your decisions by association and correlation is that not everything is associated or correlated with one another every time.

It’s an imperfect assumption (you know what they say about assumptions) to think that just because something was associated with another a few times that it will be associated with that same thing in the future.

People used to associate cigarettes with good health, and high status. See my point?

Application to Trading

Past performance is not indicative of future results. We’ve all heard that. I don’t need to repeat that here, but it’s worth saying.

Moreover, just because some catalyst happened in the market, and things played out one way does not mean that they will play out that way again.

If the Fed raises rates, and the assumption (there’s that word again) is that the market will take a dip, don’t expect that to be the future outcome every time the Fed raises rates. To do so is to fall into the trap of the Association Bias.

Anything can happen.

Cognitive Biases 11-15

11. Pain-Avoiding Bias

What is it?

The full title of this is Simple, Pain-Avoiding Denial (Keyword here Denial). Charlie gives the story of how back in WWII when an acquaintance flew over the Atlantic Ocean and just disappeared.

The person’s mother (who Charlie describes as “very sane”) refused to believe that her son had died. The Pain-Avoiding Bias is the tendency that any normal person can fall into, without any regard to the legitimacy of their opinion.

Takeaways

Charlie describes this Bias as anything but noble and should be squashed

Application to Trading

We’ve all had those times where we’re in a position, and we don’t want to look at the screen to face the reality that it’s a loser. The feeling of just setting it aside and avoiding the pain of actually realizing that we’re losing money can be tough.

Don’t fool yourself.

Open your account. Face the choices you’ve made. Hoping that a loser will turn into a winner is utter nonsense.

Face the reality, take care of it, and move on.

12. Excessive Self-Regard Bias

Kanye West. Enough said.

What is it?

Ego. The Excessive Self-Regard Bias can be likened to the “endowment effect”, meaning that people tend to overvalue things once they own them– once it’s theirs. For instance, a car becomes more value to someone once they own it than before they bought it.

Charlie gives a great example of this in his book Poor Charlie’s Almanack. He gives the example of a foolish man playing the lottery.

Although the odds of the lottery are no different for anyone else, he thinks that because he picked his own special numbers that there is an unequal weighting in his favor.

At its essence, the Excessive Self-Regard Bias is the tendency we have to place an unequal weighting on our own thoughts, opinions, ideas, or actions.

While you may be thinking to yourself, “I don’t do that. I’m a pretty humble person”, you’re probably right for the most part.

I’ll give you an honest and open personal example. In a few of the early businesses and ventures that I’ve been a part of, from a young age until now, I would always think that I had the edge, because well… It was me.

It didn’t matter what the statistics were. I thought I was special, or that I had the advantage because I knew something that others didn’t. Well, I’ve learned my lesson many, many times (like too many to count) at how dangerous that mode of thinking can be.

It’s even more dangerous when you’re not aware of it like so many people are.

Takeaways

The takeaway here is that you should always be cautious of your own opinion, and realize that the odds for you are no different from they are for anyone else.

Ray Dalio has a quote that I just love. With a stellar track record like his, you would think that he has a crystal ball to call the markets. His secret? He always asks himself, “How do I know I’m right?”.

Application to Trading

How do you know you’re right? Is it because you woke up on the right side of the bed this morning? Did you rub your rabbit’s foot or other lucky charms?

Question everything you do.

If you’re bullish, why are you bullish? Why shouldn’t you be bearish?

If you’re bearish, why are you bearish? Why shouldn’t you be bullish?

It’s tough work to stay objective. But hey, if it were easy… you know the saying.

13. Over-Optimism Bias

What is it?

This one is usually part two to the Simple, Pain-Avoiding Bias (read: Denial). Typically, when someone is trying to avoid pain they will preoccupy themselves by focusing on the brighter things in life.

“When life gives you lemons, ask it for salt and tequila as well” – Unknown

It would be pretty hard to be in denial of unwanted events if you could not focus on other more pleasant things.

Remember the lady whose son had clearly died after disappearing over the Atlantic (Association Bias at play. We don’t have actual proof)? She was over-optimistic that her son was still alive.

I mean… even though he never turned up he could still be alive, stranded on an island somewhere. “Wilson!!”

Takeaways

When there are pressing issues to take care of, or if the odds don’t support your optimism, take a step back and assess yourself.

I believe optimism is a good thing. It’s better than being pessimistic. Nobody wants to be around a Debbie Downer. At the same time, nobody wants to be around someone who constantly has their head in the clouds either…

Application to Trading

If you’ve been reading through all of these, you’ve probably noticed that I talk a lot about managing your downside. This one is no different.

It’s good to be optimistic at times about the potential gains you can make in your trading. However, optimism cannot replace the function of risk management.

As a trader, you’re a professional risk manager. Optimism (I’m sorry to say) has no place in a risk manager’s toolkit.

You assess the probabilities and play the odds. That’s it.

14. Deprival-Super Reaction Bias

What is it?

The Deprival-Super Reaction Bias is the irrational overreaction people tend to have at the possibility of losing things.

This one kind of annoys me when I see it. That’s probably because I live in Scottsdale, Arizona. If you’ve ever been to Scottsdale, you know it’s a bit of an upscale, ritzy kind of town.

So I really wouldn’t really classify most people’s problems here as problems. Although, that still doesn’t mean other people here don’t freak out and fear for their lives when a door to door salesman comes around. I digress…

This Bias mainly comes about at the thought of losing something. Loss-aversion is one of the most powerful psychological mechanisms in the brain. It’s actually more powerful than the possibility of gain.

Takeaways

Chill out. I find that it’s a good idea to distance yourself from the incoming possibility of loss, and the reality of your current situation.

Run a mental audit, and see if this thought is rational or irrational. If it is a real possibility that you might lose (whatever it is), take steps to ensure that doesn’t happen.

Use the energy that you would otherwise spend worrying about it, and find a way to fix it.

Application to Trading

“The market’s crashing! I’m ruined!” Is that an insensitive quote? A little. I don’t mean it to be. I recognize people’s livelihoods are at stake in the Financial Markets. I get that.

That said, when the S&P has a good-sized down day, ask yourself “Is this a liquidation break of just profit taking? Or is there something bigger here?”

Don’t overreact. Stay levelheaded.

15. Social Proof Bias

What is it?

Social Proof is the bias we have towards things that other people are doing. We as people tend to follow the crowd. Take this example for instance:

You’re visiting some friends in their hometown. However, you’ve never been there before.

Your buddy was at work when your plane landed, so he couldn’t pick you up from the airport and take you out to lunch.

You’re starving and don’t want some overpriced, nasty airport food. So you decide to hit the town and find something local.

You walk down the street a bit, and you see there are two restaurants right across the street from each other.

The first one is a nice restaurant. Low lighting and the menu has some good food on it. It’s a bit of an upscale place. “Probably has some good food”, you think to yourself.

Then you look across the street and see “Average Joe’s Pizza Parlor”. At Average Joe’s Pizza Parlor, the windows are wide open, and you can see a ton of people inside laughing and enjoying themselves. In fact, there’s a line out the door, and around the block of people waiting to get in!

Which one do you choose?

You chose Average Joe’s Pizza Parlor, or at least the choice between the two was extremely difficult.

Why?

Average Joe’s Pizza Parlor had Social Proof.

There were a ton of people inside and a line around the block. If there were that many people wanting to go to a place called Average Joe’s Pizza Parlor, there must be something very, very special about it.

Social Proof is essentially following the crowd’s behavior. We do this because our minds already have a million things going on that we’re thinking about, so it’s much easier to follow what other people are doing in an effort to not have to deliberate on yet another thing.

Takeaways

Social Proof Bias is a very powerful thing. “If everyone else is doing it, I should do it too”.

Social Proof can be used as a good tool to help limit the cognitive strain experienced in decision-making. However, it should not replace thoughtful deliberation, especially on important issues.

Application to Trading

Grandma just told me she gave her broker permission to put her whole account into Gold Futures. When I asked her why, she said: “the man on CNBC said that ‘everyone’s buying gold’, so I thought I’d buy it now before it goes up too much more”.

If everyone is buying Gold, it must be a good investment, right?

To be a Contrarian, or to not be a Contrarian. That is the question…

Look, there’s a time to follow the trend, and there’s also a time to be a Contrarian. Make sure that all of your trading and investment decisions are your own, and based on your own analysis and reasoning.

Cognitive Biases 16-20

16. Contrast – Mis Reaction Bias

What is it?

Contrast-Mis Reaction Bias can also be likened to Anchoring. It’s a Bias that causes people to place too much importance on the first piece of information.

It was either Thinking, Fast and Slow, Predictably Irrational, Pre-suasion or Influence (Hey, I get confused. At least I cited it…) that gave the example of a businessman who could come up with these elaborate plans for a new project.

In reality, this businessman just wanted a very small piece of what he was asking for.

So when his boss said no to the magnitude of his original plan, he would follow it up by asking for the smaller piece to which his boss would say yes.

His boss was anchored to the first plan that was irrationally complex and big (I mean we’re talking stuff that only happens in the movies), so when he was asked about the second, smaller plan he was much more willing.

Take note when you’re submitting your next business proposal.

Takeaways

Whether you’re asking your boss for a raise, or you’re asking your parents to go out on the weekend, you will be more successful if you start by asking for exponentially more than you want (but not enough to piss them off).

They will, of course, say no.

Then you hit them with the smaller offer (the one you want), and it’s lights out. You’ll more often than not get it.

Application to Trading

The application to trading here is that rather than asking for something, be aware of your own anchoring. Don’t anchor your expectations to make $1,000 a day if you’re trading a one-lot.

17. Stress – Influence Bias

What is it?

Stress-Influence Bias is the tendency to achieve optimal performance through mild stress, achieving no action with lack of stress, and achieving paralysis through extreme stress.

What this Bias essentially boils down to is the difference between distress and eustress.

Distress has the capability of destroying anyone’s spirit. Once this spirit is destroyed enough times and whittled down to a spec of dust, it becomes nearly impossible to restore someone’s spirit. Check out the Three Stages of Breakdown (short read, way shorter than this article) for more info on rehabilitating someone after massive amounts of stress.

Eustress, on the other hand, is what drives athletes to excel in the final moments of the game. It’s what causes ordinary people to achieve extraordinary things when it matters.

Both things are still “stress”, but they are varying levels of stress.

A little stress will, more often than not, induce Eustress. Too much stress as a whole and you have Distress.

Are you with me? If you’re a bodybuilder, or someone who likes to workout, lifting weights at the right volume and frequency will induce muscle growth. If you overdo it on the volume or frequency, you will overtrain yourself and it’s very hard to work your way out of being overtrained.

Takeaways

If you’re a coach, a mentor, or someone in the position of power, you can effectively motivate people to achieve great things with the right amount of stress. This is what leaders do. They strategically stress their followers so that they will flourish and grow.

Jerk bosses bark out orders and expect to squeeze out the last drop of productivity from their employees. The employees eventually go into a state of distress, and quit.

The boss doesn’t care though. He thinks they’re expendable.

Little does he know he could achieve better results if he just shifted his way of doing things.

Application to Trading

If you’ve noticed, trading is the hardest easy money you will ever make. This stuff is hard. Inevitably you will have losing streaks where things just don’t make any sense.

Don’t feed the fire by getting upset, angry, and distressed. Those are the times where you lay off the gas, deleverage, and take it easy.

You don’t want to be totally lackadaisical, you still need a little bit of stress (Eustress) to enable you to act.

However, if you try to press through those periods where nothing makes sense, you might screw things up so badly where you get knocked out the game.

Find your balance.

18. Availability Bias

“An idea or a fact is not worth more merely because it is available to you”

What is it?

We, Humans, are resourceful. We make do with what we have, with what is readily available to us. As a result of this, we tend to ignore the things that require some effort on our part.

The Availability Bias is essentially our brain overweighing the importance of the information that is easily and readily available to us. Now if you’ve read Thinking, Fast and Slow by Daniel Kahneman, this Bias would make more conceptual sense.

In Thinking, Fast and Slow, Kahneman describes two modes of thinking that exist in all of us. He calls these two modes System 1 and System 2. Here’s a very, very general overview of the two.

System 1 is the fast, intuitive kind of thinking. It’s the thinking that you use when you’re driving a car, or doing something that doesn’t require a lot of thinking.

You don’t have to calculate a bunch of things like wind speed or the mathematics of the acceleration and deceleration of the car… You just drive.

System 2 is the slower and more deliberate kind of thinking. It’s the thinking that’s required to solve complex math problems for example.

The thing about System 2 is that it’s lazy. It doesn’t really like to work, so it leaves all of the basic, day-to-day decisions to System 1. Anytime System 2 does have to be employed, it’s very stressful.

Kahneman defines this kind of mental stress as cognitive strain.

So in other words, people tend to succumb to the Availability Bias easily by responding without thinking (System 1). Everyone does it. The trick is to train your System 1 with the correct information, by using your System 2 thinking to ingrain it into your System 1.

This happens with practice and repetition.

Takeaways

Making decisions based on information that is readily available, or on information that just comes to mind is part of our brain’s effort to save energy in case more important things come up in our lives.

The brain is constantly searching for ways to shortcut things and to conserve energy as a survival mechanism in case we need our energy for Fight or Flight.

As with all of these Biases, the Availability Bias can be overcome by simply pausing for a moment to deliberate about things.

Application to Trading

Seek out all relevant information before putting money at risk. You should consider the relevant and important factors in case there is a huge piece of information that you missed.

Remember to look at the markets in the context of the larger picture.

19. Use-It or Lose-It Bias

What is it?

The Use-It or Lose-It Bias is the tendency we have as humans to forget information or skills the less we use them. For instance, the ability to conjugate verbs from your high school Spanish class has probably been long forgotten because you didn’t keep up with your skill.

That’s really all this Bias is.

Takeaways

The Use-It or Lose-It Bias is just a tendency to forget things that we don’t actively participate in.

Why do you think black-belts are constantly training? They know that if they don’t keep their skills sharp, they won’t be prepared when they need it most.

You can’t just train once, become a pro, and then that’s that.

Amateurs train once. Professionals train forever.

Application to Trading

Be wary of taking a break for too long from the markets. Those skills that you worked so hard to build up, that intuition and analytical ability, can take a hit if you don’t keep up on your skill set.

Always be refining your abilities.

20. Drug – Mis Influence Bias

What is it?

Charlie doesn’t go into much detail on this one. He simply states that drugs are bad and that they hamper cognition and outcome of life. I’d largely agree with him.

Takeaways

Don’t do drugs.

Application to Trading

Don’t do drugs.

Cognitive Biases 21-25

21. Senescence – Mis Influence Bias

What is it?

The Senescence – Mis Influence Bias is the natural decay in mental capacity as people age. Charlie says that through continuous thinking and learning, the process of this mental decay can be slowed down.

Maybe that’s why he’s 93, and alive as ever.

Takeaways

Continuous thinking and learning help to slow the mental decay that takes place as you age. By continuing to learn into your old age, you can remain with it.

By continuing to think and learn at a young age, you can take full advantage of your life.

Application to Trading

Always be learning. Never stop learning. Remember, as traders, we don’t have any secret sauce.

It’s all a skill set that needs to be continually made better.

22. Authority – Mis Influence Bias

“Think for yourself, or others will think for you without thinking of you.” – Henry David Thoreau

What is it?

The Authority – Mis Influence Bias is the tendency that people have to remain a follower of those in (perceived) positions of power.

Society, for the most part, is hierarchical. Whether it be your boss, your parents, or the government, there is always a higher authority dictating things.

The mistake is to blindly follow these authorities just because they are authorities.

I’m not saying to not follow the law or rules, by the way. Charlie is saying that it’s a mistake to follow orders “just because someone says so”.

Takeaways

Think critically, and think for yourself. Just because someone in a higher position of authority says something, that does not make it true.

Application to Trading

Trading tips are typically bombs disguised as gifts. Whether it be from trading chat rooms to people on the television, almost no good can come from following other people’s trading tips.

Good trading comes from independent thought.

You should probably use yours.

23. Twaddle Tendency

Focus on what you’re doing, when you’re doing it

What is it?

Twitter, Facebook, LinkedIn, YouTube, Google… It’s a huge distraction. The Twaddle Tendency is the tendency that people have to spend too much time on nonsense. That’s pretty much all that Charlie says.

Takeaways

Don’t waste time on things that don’t matter.

Application to Trading

Stop looking at Twitter, or Facebook, or whatever else when you’re trading. When you’re trading, focus on the market.

24. Reason – Respecting Bias

What is it?

No matter how irrational people can act, people like rationality and reason. The Reason – Respecting Bias is the tendency we have to want to know why we’re doing something.

For instance, have you ever noticed how young kids always want to ask why? “Why? Why? Why?”

As we mature into adults, we still want to know why.

Takeaways

We are more reluctant to do things when we don’t know why we are doing them. Conversely, we are much more willing to do things when we know why.

Application to Trading

There’s not really much to explain or apply here. When we know why we’re doing something, it’s just better. We’re more willing to do it.

25. Lollapalooza Bias

What is it?

The Lollapalooza Bias is when two or more Biases work in conjunction to amplify logical delusions. This mainly occurs when we really want something to happen.

So we subconsciously look for ways that our opinions or perceptions to be correct, and at the same time, we succumb to multiple Biases.

An example, and I already kind of touched on this, would be that the Pain-Avoiding Bias is usually used in conjunction by the Over-Optimism Bias to avoid pain and at the same time focus on the desired outcome.

Takeaways

Be wary when expecting the desired outcome. By trying to force your will on things you cannot control, your objectiveness will likely falter.

Application to Trading

Don’t force your opinion on the market. You will be met with great resistance, and ultimately your endeavor will fail.

Conclusion

The man behind Warren Buffet Hey, you made it!

(Or did you just scroll to the bottom? Get back up there, read it, and thank me later)

That was a long article. The odds are if you started reading this article, and wanted to quit, that green line across the top and the fact that you subconsciously needed to finish what you started is what got you through it.

Remember the Inconsistency Bias?

That’s the cool thing about understanding this 25 Cognitive Biases. Not only can you affect change in yourself, but you can also see the world and other people’s actions in a different light.

You might think you’re a psychic when you predict the reasoning or the outcome of other people’s irrational behavior.

Don’t break out the Ouija board just yet. You’re just more aware of human behavior. You can thank Charlie Munger for that.

Anyhow, thanks for reading. Let me know what you think in the comment section!