A bat and ball cost a pound and ten pennies. The bat costs a pound more than the ball. How much does the ball cost?
The vast majority of people answer 10 pence.
The impulse answer is both obvious and wrong.
The correct answer is in fact £1.05 for the bat, and £0.05 for the ball (answer at the bottom of the page).
For over 50 years, Daniel Kahneman a nobel laureate and professor of psychology at Princeton University has been asking similar questions and analysing our answers. For many years, theoretical models in many academic departments such as psychology, economics and the social sciences, had taken for granted that human beings are essentially rational beings. But Kahneman and others have shown that we are not nearly as rational as we like to believe.
When people face uncertain situations, they don’t go looking for statistical evidence or carefully evaluate the information to hand (as the models predicted). Instead they rely on mental shortcuts such as the one you probably used earlier, and it is these shortcuts which often lead to poor decisions.
According to a study in the Journal of Personality and Social Psychology, in many instances, smarter people are more vulnerable to these thinking errors.
Given that the default shortcut is usually the route that requires minimal mental effort, what should investors do? I would recommend reading Daniel Kahnemans book http://www.amazon.co.uk/Thinking-Fast-Slow-Daniel-Kahneman/dp/0141033576 but don’t expect a miracle cure. Given that many of our mental shortcuts are largely subconscious, many are relatively immune to conscious introspection.
Over time however, you may learn to manage some of the more dangerous mental shortcuts.
b+1=a, or b=a-1 (2)
Substituting (2) into (1) gives:
Substituting a=1.05 into (1) gives: