PART 1 – Making the Correct Decision isn’t Always the Simple One!
Decisions, decisions, decisions
There is no more frustrating and tiresome process than having to constantly make choices and decisions – e.g. the worst of all: “what are we having for dinner tonight?” – cringe. Yet decisions, from choosing a dinner to choosing a career, arrive in a variety of forms throughout our lives and essentially, they shape who we are and who we become.
It is only logical that when making a choice we do everything in our power to make the best one.
This series of 4 parts, is intended to track and indicate common misconceptions and decision making errors we often experience without actually knowing it.
The Ivy League Test
Let’s begin clearing up some misleading thought-patterns that are often associated with bad decision making.
Answer the following questions as quickly as you can, after reading them:
- A bat and ball cost $1.10. The bat costs 1 dollar more than the ball. What is the cost of the ball?
- At a dry cleaner, it takes 5 machines only 5 minutes to clean 5 suits. How long would it take
a 10 machines to wash 10 suits?
Did you perhaps say the ball costs $0.10 and it will take 10 minutes to clean the suits?
Unfortunately this would be incorrect (read on the answers are below). If you didn’t say that, you have potentially succeeded in forcing out the obvious answer and applying your mind – well done!
The common fallacy is to make a decision based on the simplest answer that comes to your mind. This is often the route to bad decisions. Intuition/your gut can be a good indicator in many cases but never forget to apply doubt to a decision before isolating an answer.
Question, question, and question some more.
Skepticism can be an admirable trait when making decisions, it will allow you to eliminate the obvious and often incorrect answer.
The Correct Answer:
The correct answers to the questions above would be:
- the ball cost $0.05 and;
- the machine takes 5 minutes to wash the suits.
If you managed to get this without difficulty you have outdone most students at Ivy League institutions who were posed similar questions and failed.
If you need the answers explained: the ball costs $0.05 and the bat costs $1.05 ($1 more) so together they cost $1.10. The machines take the same amount of time to wash a suit (5 minutes). For example if you had 100 machines washing 100 suits it would still take each machine 5 minutes to wash its respective suit.
Obviously, it’s a good start to understand that you should be questioning the “quick answers” before blindly making a decision. Perhaps you now feel you are well on your way to making some good decisions. Let us try another quick example before over confidence strikes:
- If you travel to your work at a speed of 100 KM/H and then travel back home at a speed of 50 KM/H. What is your total travelling average speed?
If you said 75 KM/H, I would encourage you to “SLOW DOWN” and try again . . .
PART 2 – Neglecting the effects of compounding
Perhaps after reading Part 1 and having successfully eliminated the “obvious” you are ready to be challenged or alternatively you are only still reading to get the answer to the question above? The answer is 66.6 KM/H.
Ready for a challenge?
Confident that you can now eliminate the easiest answer and replace it with the less intuitive and often
better solution you are ready to move on. Let us try our skills at another misconstrued fallacy that makes an intuitive answer not always the best option.
First, answer this question and write it down:
- Taking an ordinary piece of A4 paper (approximately thickness is 0.05 mm or 0.002 inches)
and presuming you were able to fold it 50 times, what do you think the thickness of the
paper would be after the 50th fold?
Before we answer the question, let’s try to provide some direction as to how you could go about getting to the answer.
Effects of Compounding
Most people have heard of this quick experiment but let’s put you to the test all the same:
You are going to be given 2 options for the next 30 days (1 month) and must be ready to choose one instantly
upon reading them. Option 1 or Option 2. Read them once and make your decision straight away.
Ready? . . .
- Option 1: You are given R 1,000 every day for the next month
- Option 2: You are given 1 cent on day one and it will double every day for the next month.
What do you decide, Option 1 or Option 2?
If you choose Option 1 you have fallen victim to what may have been the intuitive answer. It naturally seems to be the better option as opposed to taking a meager 1c that doubles. This form of decision making occurs frequently and is largely due to individuals failing to consider the effect of compounding or believing the effect is not significant.
Think about your interest on your mortgage and that half basis point you could have saved, was it worth fighting for?
By choosing Option 1 you would have ended up earning a lot less than you could have (even assuming you choose to astutely invest your money with a strong returns).
Perhaps you were one of those people that selected Option 2. Did you do this because you guessed it was more profitable or because you knew it was a trick or even perhaps it was just a gut feeling? I suspect the heading of this part might have even given it away. What we really building towards is: do you know how much more you would have earned by selecting Option 2?
Can you put a figure on how much more you would earn taking Option 2?
Well assuming you went and took Option 1, after one month you would have R30,000. We have excluded any investment returns for simplicity. This money is not too bad for a fun filled overseas holiday.
Should you have selected Option 2, after 30 days you would have R10,737,418.23.
Becoming a millionaire overnight versus a holiday was the difference between an intuitive answer and the correct answer.
Overlapping the 2 graphs and using different axes, we see it is only at the end of the month that the compounding really takes effect. In fact, up until day 21 you would have earned more by taking the simple R1,000 per month but by day 27 you are in the millions.
To make the most of compounding you should save early and make use of tax incentives. Read more about Tax Free Savings.
If you got close to the right answer and knew it would be in the millions, then well done – proving you are applying your mind! If not, do you want to go back and change your answer to the paper question above? . . .
The answer to the paper question is as follows. The approximate thickness of a piece of paper folded 50 times would be greater than the distance from us to the moon. Surreal right? Maybe you don’t believe me, but mathematics does not lie and you are welcome to check what 0.05mm doubled 50 times is (or the distance to the moon).
The answer if you are interested is 28 147 497 671 065.6 mm or 1 125 899 906 842.62 inches.
Ready for a real challenge? Part 3 is up next.
PART 3 – Hiding inside an average!
At this stage you have already read everything in Part 1 and Part 2 and it may have seemed pretty straightforward right? You feel like you are ready to step it up a little.
The Fund Manager Test
Let’s put you to the test and see if you can answer something a little more practical to the investing world.
You are a Fund Manager and have 2 funds each with their own investment products.
Fund 1 is performing exceptionally well, while Fund 2 is lagging behind substantially.
In fact, every single investment product in Fund 1 is performing better than even the best products
in Fund 2.
The board has told you that you must improve each of the fund’s individual performances if you
want to get your annual bonus.
Where do you even start?
Are you thinking about selling off Fund 2’s investments and buying the investment Fund 1 has?
You may have already missed the run and this would not change the past performance. Not to mention the associated selling and buying costs could be large and further exasperate the poor performance of Fund 2. Its a difficult position to be in.
There is however a simple answer and it can be found by using “averages”
One of the best ways to manipulate decision makers is by manipulating averages. Averages are the grey area that allow you to mislead those who do not apply their minds.
Although before explaining this to you I must remind you that “with great power comes great responsibility” – Uncle Ben
The proposal: simply move the worst performing product in Fund 1 to Fund 2’s portfolio. It’s really that easy!
In one quick internal move that would cost very little you will have improved Fund 2’s performance and also you would have improved Fund 1’s performance as well.
The only decision left now would be “what to spend your large bonus on?”
Skeptical if this is really true? Good! Let us provide an example of how this would work.
The Burger Salesman Example
You are a Burger Sales Manager and have 2 divisions each with 3 salesmen. Division A has Salesman 1,2 and 3 while Division B has salesman 4,5 and 6.
Salesman 1 sells 1 burger, salesman 2 sells 2 burgers etcetera all the way to salesman 6 who sells 6 burgers per day.
Based on that information the average sales per day at Division A is 2 burgers (1+2+3 = 6, divided by 3 = 2) and the average of Division B is 5 burgers (4+5+6 = 15, divided by 3 = 5) Got it?
Tasked with improving your average sales is as simple as moving salesman 4 to Division A. He is the worst in Division B but the best in Division A.
Instantly and with no real effort you have improved your averages for Division A to 2.5 (Thank you salesman 4 for joining us; 1+2+3+4 = 10 divided by 4 = 2.5) and Division B to 5.5 (Thank you salesman 4 for leaving us; 5+6 =11 divided by 2 = 5.5).
Simple decisions are not always the intuitive ones and often elusive and hidden in averages. Be skeptical whenever you are referred to some sort of average. A lot of information can be hidden through the astute use of them, and even mislead you into an incorrect decision.
It may be in your interest to utilise them but beware of making decisions based on the use of averages. The above examples are more prevalent in business reports and statistics than you would dare to believe.
Making decisions on averages is a slippery slope to a nasty outcome.
Its time to round off the series with some questions on how to predict the financial markets with 100% success in Part 4.
PART 4 – How to Predict Financial Markets with 100% Success
After having read Part 1, Part 2 and Part 3 we are on to our final conundrum: How to predict the stock market 100% correctly every month. Wouldn’t that make life easy?
Being an avid reader of financial theorems and concepts, I have stumbled on to an all manner of junk, everyone has the next best theory on predicting markets or the next trick to beat the averages. Fortunately this is not one of those articles. This article really will tell you “how to become a true stock market forecaster that is NEVER wrong”, and it all has to do with the fallacy of discounting coincidence.
Well the most difficult part is getting started. You will need to find at least 100,000 email addresses of people who actually read their emails each month.
Why do you think we want you to subscribe for our monthly mail?
Taking the 100,000 email addresses simply divide it into 2 separate groups. Send an email to each group at the beginning of Month 1. To Group 1 clearly profess that a specific stock or index will rise, and to Group 2 that it will decline.
At the end of the month if the stock/index has risen then scrap Group 2 or if it has fallen than scrap Group 1. Now you are left with 50,000 people who you have correctly advised. Prepare to repeat the above steps with your new group; i.e divide in half and email out again the different guidance during month 2.
Step 4 to 12
Repeat this process for the next 12 months and you will be left with 49 people who you have correctly advised for a 12-month period every single month of the year.
By then these individuals will have no doubt about your ability to predict financial markets. They will believe you either have some insider information or perhaps you are a market genius with incredible ability.
Subsequently it would not be hard to convince them that they should invest the majority of their life savings with you, along with their friends and family’s money. With a sudden influx of cash and a quick disappearing act, you could be spending the rest of your life in a villa off some Caribbean beach.
Ponzi scheme tyrants utilise this common fallacy to their advantage
Rounding it off
Since we are not crooks and we will not be taking any innocent individuals hard earned money there is no reason not to subscribe. A monthly dosage of Finugget might end up being quite beneficial. Outside of that marketing snippet and within the broader concept of the article, there is a lesson to be learnt about saying: “what are the chances?”. The chances are sometimes really good despite what you may think. Millions of people making millions of investment predication’s every day, and within those millions of millions there is bound to be many coincidences.
An investor may spend a month getting nearly every investment decision correct and proclaim himself the next Warren Buffet. Only to lose millions the next month as he bets everything on his new found ability. The market teaches harsh lessons and you should never discount coincidence/luck. Beware of the fallacy of ignoring coincidence and assuming that someone is a real forecaster/whiz. Or even worse assuming that you are any different.
Proclaimed no better than the skydiver who says “Skydiving is safe, I have done it 1,000 times and never hurt myself” only to fall to his death the next day.
Belief should come only after the application of some level of skepticism.
All in all, after this 4-article series I can only encourage you to dig deeper and think harder before making a decision. Often there is more to tell than you would originally think, though unfortunately we don’t always have the time.