We've seen before that investors are generally attracted to a good story and tend to shy away from the hard problems associated with analysing numbers. Worse, even if people do look at the numbers they tend to be swamped by information to the extent of not knowing what's important and what's not. Although generally this is only obvious in retrospect, anyway. However, there are strong suggestions that our inclination to follow a good and particularly interesting story isn't simply stuff that happens. It looks as though this is built into our processing centres and is a driving force behind a lot of what we do on an everyday basis. We're simply misapplying the lessons of life.

Under-estimating Bad Stuff

As we saw in Investor Decisions – Experience Is Not Enough investors are, in defiance of the basic tenants of behavioural finance, liable to under-estimate the likelihood of rare events in particular situations where they're repeatedly exposed to feedback from small decisions. People only get a small sample of possible results and update their internal models slowly, so the relative rarity of a rare but extreme event fools them into under-estimating the dangers. For example, if this idea is correct then casino slot machines that pay out huge amounts but only on rare occasions would end up dying of rust in cobwebbed corners – people would decide that the machines weren't likely to pay out and give up. To prevent this happening the machines cough up regularly, just enough to confuse our return estimating algorithms. People seem to make the same calculation with minor traffic transgressions, like running traffic lights in the dilemma zone – nothing bad happens nearly all of the time, so they keep on doing it.

To Jay-Walk or Not

Although this looks a lot like Prospect Theory – one of the mainstays of behavioural finance – is wrong in fact it's more that this type of decision making from the experience of multiple blind trials with feedback is exactly the opposite of the scenarios that a lot of behavioural finance researchers have looked at. Much of this research has focused on so-called one shot, decision making from description; big decisions like taking out a mortgage or getting married. These standard experiments provide information in a written and structured form and format that's quite different from what we experience…

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