I’ve recently read a wonderful book by University of Toronto professor Keith E. Stanovich named What Intelligence Tests Miss, the psychology of rational thought. The essential question that author is addressing why intelligent people act foolishly. Nowhere is this phenomenon more true that in the world of investing.

Common Financial Folly Book vividly recounts the tales of

Book vividly recounts the tales of a mathematics professor who kept furiously buying WorldCom shares from $47 all the way to near zero, of average active investors who trade in and out of funds, buying high and selling low, and thus underperforming the benchmark buy and hold strategy by up to 75%.

3 Cognitive Minds

The explanation is found in better understand how our minds work. The explanation is found in better understand how our minds work. The author posits that humans have 3 distinct cognitive “minds”.

Autonomous Mind

At the lowest tier is our autonomous mind, which serves us for the most rudimentary tasks such as driving, basic pattern recognition (if…then), and execution of repetitive tasks which require minimum thinking.

At the lowest tier is our autonomous mind, which serves us for the most rudimentary tasks such as driving, basic pattern recognition (if…then), and execution of repetitive tasks which require minimum thinking.

Algorithmic Mind

Higher level cognitive functions are handled by our algorithmic mind. This mind helps us apply analysis, logic and is the source of measured IQ. May computational tasks such as financial analysis, forecasting, stock picking, and accounting are handled by the algorithmic mind. This mind is the source of our strategies and production systems.

Reflective Mind Then there is our reflective mind, the source of our thinking predispositions. Indeed, this part of the mind bears the most responsibility for our long-term financial health and wealth. Buffett calls it the “wiring” that helped him succeed. This mind is a custodian of our beliefs, goals and general knowledge (or

Then there is our reflective mind, the source of our thinking predispositions. Indeed, this part of the mind bears the most responsibility for our long-term financial health and wealth. Buffett calls it the “wiring” that helped him succeed. This mind is a custodian of our beliefs, goals and general knowledge (or mindware).

Folly is Alive and Well

Are we sufficiently open-minded to facts and realities of the world? Are we able to exercise discipline and override the innate impulse to act before completing the analysis? Do we fall victims to overconfidence in our own predictions and abilities (leading to excessive risk taking and overtrading)? Are we cognitive misers and rely on simple pattern recognition to pick our investments? Do we suffer from myopic loss aversion that forces to “bail out” at the first sign of dip, resulting in the familiar “buy high less low” pattern? Do we tend to hold on to our losers whilst cutting the winners short, or as Howard Marks labeled it cutting the flowers and watering the weeds.

Investing is not unique amongst the subjects of human endeavor that affords individuals that act rationally and avoid the folly the disproportional rewards for their efforts. Whilst the book won’t cure our folly, author’s message that rationality is fundamental a learnable skill is positive statement for all of use that thrive to become little less ignorant tomorrow that we’re today.