The notion that the future is unknowable is difficult to accept. It goes against hundreds of years of human progress where we’ve learned how to predict things and thus control what is going to happen. Nevertheless, our lives wouldn’t be as enriching in terms of experience. Imagine how dull it would be to know with certainty what tomorrow will bring. This post discusses the difference between risk and uncertainty with examples. You’ll learn about some of the most popular behavioural biases that manifest when we’re faced with risk and uncertainty, particularly when it relates to our investing decisions.

1. Aversion to ambiguity
2. The law of small numbers
3. Gambler’s fallacy
4. Hot-hand effect
5. Learn how to deal with risk and uncertainties

In 1961, Daniel Ellsberg performed an experiment whereby he set up two urns, both of which contained 100 balls. The first urn contained 50 black and 50 red balls, whilst the second urn contained a combination of black and red balls (an unknown probability). Participants in the experiment were asked to select which colour ball they wanted to pick, and out of which urn they wanted to pick it.

Speaking of probabilities, there’s another thing that we do wrong which is putting too much emphasis on small quantities of information.

Consider a coin toss. Every time you toss a coin there is a 50% chance that it will land on heads and a 50% chance that it will land on tails. But when we start tossing that coin and it lands on tails 3 tosses in a row, we may feel like the next toss has a higher probability of landing on heads. But that’s not accurate. The odds are always 50/50.

This approach would be appropriate if you had that urn of red and black balls and randomly picked out 3 balls that were all black and didn’t put them back in the urn. In that situation, yes, the probability of picking a red ball does increase. But when tossing a coin, each outcome is entirely independent of what came before and after.

As Tversky and Kahneman rather bluntly put it in their journal paper:

Basically, we’re statistically stupid not the smartest. This is acknowledged in a concept known as Knightian uncertainty. It acknowledges that limitations in our knowledge coupled with a degree of ignorance results in our inability to predict future events. And thus our poor understanding of risk and uncertainty in decision-making.

Can you see the problem here?

Gambler’s fallacy exists because we don’t understand statistics, or at the very least, we don’t understand the difference between a random process and one that is not.

Both Gambler’s fallacy and the hot-hand effect are using the law of small numbers in believing that past events change the probability of an event happening in the future.

Curiously, we can demonstrate both Gambler’s fallacy and the hot-hand effect at the same time. A university experiment that used random data from a roulette wheel game showed that participants displayed gambler’s fallacy when predicting the outcome of a sequence of spins, but at the same time, they believed that their predictions (which were based on the same random data) were influenced by the hot-hand effect.

That means we need to stop worrying about our lack of control over our investments. Rather, go do something constructive, like BASE jumping or mountain climbing, where you actually have an element of control.

• Heuristics and biases in decision making – This was the first post in the series which shares some behavioural economics research. Specifically, the heurstics and biases that influence our relationship with money. It uses System 1 and System 2 thinking examples from Daniel Kahneman’s New York Times best selling book, Thinking Fast and Slow, to help us be more conscious of the workings of our brain. 

• Mirror, mirror, on the wall, stop telling me I’m wonderful – This post focuses on the impact of overconfidence bias in decision making. It introduces the illusion of knowledge bias and the illusion of control bias to illustrate the difference between confidence and carelessness. It also discusses the better than average effect, the self-serving bias and fundamental attribution error. You’ll learn how to confront some unpalatable truths and get out of any false sense of comfort (if you’re up for the challenge?).

• Why you can’t argue with a vegan – Ballsy title, we know. But if you read the post you’ll (hopefully) understand why. We’ll be discussing confirmation bias. It’s one of those psychological biases that you can see everywhere. We’ll also touch on cognitive dissonance theory. We all struggle with these biases. They’re both humorous and serious. But because of that, it’s useful to know how to avoid confirmation bias when you need to.

• Size does matter… when it comes to framing – This post uses framing effect examples to show how framing bias influences the way we interpret information and make decisions. We discuss glossing, the compromise effect, and how the size of the frame can influence the volatility of your investment portfolio.

• Loss aversion vs risk aversion – Once you understand framing, you’re ready for this post. It introduces an incredibly powerful bias known as loss aversion. It also touches on prospect theory, the disposition effect and impression management.

• Anchors pulling you down? – Anchoring bias is a straightforward behavioural bias that causes us to focus on a certain initial value and then make decisions with reference to it. This posts looks at some examples of this anchoring effect.

• The danger of the default – Default options nudge us to make better decisions. The option of opting out also respects freedom of choice. This post unpacks this notion of libertarian paternalism and the perils of status quo bias.

• Regret, it’s not a nice feeling – Regret influences the decisions we make and pushes us to conform to social norms. Examples of regret avoidance show us how this makes complete sense yet no sense at all.

• When the past influences the future – The Concorde effect is a famous example of sunk cost investment. Too often we invest time, money and energy into something we should’ve just abandoned. This post looks at some examples of how sunk cost fallacy affects our human decision processes.

• What’s mine is more valuable – In this post, you’ll learn why you place extra value on things you own. The endowment effect has implications for our investment portfolio, bonuses and consumer behaviour.

• How to improve self-control – Self-control is an essential life skill. It’s what separates humans from the rest of the animal kingdom. Learn how to improve self-control to achieve your long-term goals.

• Procrastination is the enemy of success – We know procrastination is the enemy of success. But while it looks like laziness, it’s often just mental exhaustion at play. Learn how to overcome procrastination.

• The problem with wanting it now – When you delay instant gratification, you will experience long-term satisfaction. It’s the hyperbolic vs exponential discounting debate. Don’t let present bias win!

• The power of first impressions – The order of information influences your decisions. First impressions matter! It’s all got to do with primacy and recency effects.

• We prefer wrong information to no information – Availability bias and survivorship bias influence our decision-making. We make decisions based on the information available to us.

• Stop stereotyping – Representativeness heuristic refers to the fact that we stereotype. It’s a mental shortcut. But beware of making unfounded comparisons.

• Mental Accounting – Money is money! Or is it? Mental accounting says we place different values on different money which leads to irrational decision making.

• Money Illusion– Money illusion is a sneaky bias. It causes us to focus on the amount of money in our hands, rather than it’s purchasing power.

• Home bias – We invest close to home and in what we know. But this lack of diversification results in missed opportunities. Say hello to ‘home bias’.