Individual Investors Part 1 Heuristics

Summary

In this video, the speaker discusses how individual investors often become their own worst enemies, citing the wisdom of Benjamin Graham. The speaker explains why finance is more challenging than accounting, emphasizing the difficulty humans have with probability. Through relatable examples, like coin flips and stock successes, the speaker illustrates how investors tend to overestimate the chances of success by relying on mental shortcuts. The concept of the 'availability heuristic' is explored, showing how memories of successful companies like Google can bias judgments about new investments, leading to overconfidence and poor decision-making.

Takeaways

• 😀 Human beings excel at adding and subtracting, but struggle with understanding probability.
• 😀 Finance requires a grasp of probability, which is harder than the simpler skills needed for accounting.
• 😀 Simple arithmetic problems, like 2+2, are easy for most people to solve, but probability problems are much trickier.
• 😀 The probability of flipping two heads in two coin flips is 25%, but people often struggle to grasp even simple probability problems.
• 😀 The probability of getting exactly three heads and one tail when flipping four coins is also 25%, though most people don't know this.
• 😀 Even well-educated people, like software engineers, often struggle with probability problems unless they've had specific training in combinations and permutations.
• 😀 Without regular practice and formal training, most people can't solve probability problems accurately.
• 😀 Our intuitions around probability are weak, and mental shortcuts (heuristics) can lead us astray.
• 😀 The availability heuristic influences our perception of likelihood, leading people to overestimate the chances of success based on easily recalled successful examples like Google.
• 😀 Investors tend to think of successful companies like Google, but often overlook failed companies, making them overly optimistic about new IPOs.
• 😀 Biases, such as overconfidence and reliance on heuristics, can lead individual investors to make poor decisions in trading and investing.

Q & A

What is Benjamin Graham's view on an investor's biggest problem?

Benjamin Graham believes that an investor's biggest problem, even their worst enemy, is likely to be themselves.

Why does the speaker consider finance harder than accounting?

The speaker believes that finance is harder than accounting because, unlike accounting which involves simple addition and subtraction, finance requires an understanding of probability, which humans are less intuitive about.

What is the difference between adding numbers and understanding probabilities, according to the speaker?

While humans are generally good at adding numbers (e.g., 2+2), they struggle with grasping probabilities intuitively, such as calculating the likelihood of specific outcomes in a coin-flipping scenario.

What is the probability of both coins coming up heads when two coins are flipped?

The probability of both coins coming up heads when two coins are flipped is 25%, or 1 in 4.

What happens when the speaker makes the probability problem more complex by flipping four coins?

When flipping four coins, the probability that exactly three coins come up heads and the other one comes up tails is also 25%, or 1 in 4, but many people do not intuitively know this answer.

Why did some Google engineers know the correct probability answer?

Some Google engineers knew the correct probability answer because they had taken courses in combinations and permutations, which provided them the tools to solve such problems.

How did the speaker's daughter demonstrate the difficulty of solving probability problems intuitively?

The speaker’s daughter conducted a project where she asked people simple coin-flipping problems, and their answers varied widely, demonstrating that people do not have a good intuitive grasp of probabilities.

What is the availability heuristic, and how does it affect investors?

The availability heuristic is a mental shortcut where people judge the likelihood of an event based on how easily examples come to mind. In investing, this can lead investors to overestimate the likelihood of success for a new IPO by focusing more on well-known successful companies like Google and less on those that failed.

Why is it harder for people to think of companies that went bankrupt since the year 2000?

It's harder because successful companies are more memorable; they are still around and visible, whereas bankrupt companies fade from public memory and are less likely to be thought of.

How does the availability heuristic influence an investor’s decision to invest in a new IPO?

An investor might overestimate the probability of a new tech IPO being successful because they more easily recall successful companies like Google, Apple, and Microsoft, while they are less likely to recall the many companies that have failed.