This is Part 2 of a 2-part article on the human cognition of risk and debt. Part 1 can be found here.

In our last post, we talked about the loss-aversion mechanisms of the brain, and how they send us emotional signals that help us avoid unwise risk. We also noted that there were about ten or twelve cognitive biases that tend to interfere with that mechanism, keeping it from kicking in when it should. Here are a few of the major cognitive distortions that disable our ability to objectively conceptualize the risks of debt:

Aversion to Sure Loss: “If I don’t take this risk, I can’t get back where I should be.”

Loss aversion can hurt us as well as help us, because if we feel that we are “down,” we tend to take increasingly risky behaviors to try and get “back even.” This was proven out in a serious of famous choice problems conducted by Tversky and Kahneman.

Aversion to Sure Loss is related to another bias called Social Anchoring. Social Anchoring is the idea that if you don’t take on this risk, everyone else will pass you by. Both biases make you feel like you might be “behind” by comparison. One World Bank policy working paper pointed out how the directors of the Big 5 investment banks were concerned not about the nature of the investments they took on, but about beating one another’s returns.

In his paper, How Psychological Pitfalls Generated the Global Financial Crisis, Professor Hersh Shefrin tells how UBS, trailing its competitors in 2006, got itself deep into the subprime mortgages that led to its downfall. Their decisions seemed to have less to do with the prudence of the investment than with their trailing position in the industry. They made the decision from what’s called “the domain of losses,” the same psychological sensation we feel when we’ve lost $200 at the blackjack table, and we “know we can get it back.”

Present Bias: “I’ll just sacrifice something later on to make room for this new debt.”

Present Bias says that we value the present more than we value the future. Sure, it’s okay to eat cake now; you’ll do more exercise next week to make up for it. Sure we can afford the flatscreen; we’ll give up something else for the next couple of months.

Present bias makes certain investment decisions more attractive simply because they’re happening right now. Have you ever bought something on a payment plan and every time you paid the bill you asked yourself, “Why the hell did I buy this?” That’s Present Bias. No matter how realistic you think you’re being about the sacrifices you’ll make later, it’s usually more of a pain than what you had in mind.

Extrapolation Bias (“Hot Hand” Bias): “The good conditions I’m experiencing now will continue forever.”

Interestingly, the volume of U.S. subprime mortgages dramatically increased in December 2006, right as housing prices were starting their fall. This is inexplicable, considering that subprime mortgages were most attractive to those who believed they would refinance at a profit several years later.

If the CDO era was a game of musical chairs, Extrapolation Bias is what leads us to believe that the music will play forever. It’s the whisper in the quiet of our minds that tells us that housing prices will increase at 10% a year forever – or at least long enough that we can get out safely.

Self-serving Bias: “Risk means less to me because my financial skills are superior.”

There’s a famous survey result which tells us that 90% of car drivers believe themselves to have above-average driving skills. By this same logic, people who are cognizant of a bubble will still participate in the bubble because they believe they have greater capability at getting out in time (see McDonald, 2009).

In his paper, Shefrin reprints some SEC deliberation testimony from 2004. The record reflects actual laughter from the group of staffers when they’re asked whether they’re capable of keeping up with the activities of the five major investment banks. The laughter reflects stunning overconfidence on the part of the SEC, who were, in reality, completely outmatched by the investment banks. Their bias in favor of their own skill blinded them to the high stakes of the situation and contributed to the crisis.

Confirmation Bias: “I haven’t seen any real signs that this debt might be unsafe.”

Confirmation Bias is the tendency to “overweight information which confirms prior views, and underweight information which disconfirms those views” (Shefrin, 2009). This is one of the more fascinating mental filters that we’ve invented for ourselves. As we progress through life, we struggle to build for ourselves a model of how the world works. The more experiences we have that confirm a certain idea (e.g. free markets are more efficient than central planning), the more we tend to cement that idea as a foundation, and build other ideas upon it.

This means that as we coast along in a certain direction without our base assumptions meeting any significant resistance (e.g. 2000 to 2006), we increasingly view them as gospel. And if some warning signs should come along that would interrupt our model of the world, we will tend to dismiss them.

Alan Greenspan had, by all accounts, a storied career as Fed Chairman. He built that career on the cement foundation of the belief in completely unregulated markets. During the later years of his career, his belief in total deregulation was so dogmatic that he under-appreciated major warning signs of impending crashes. Greenspan’s great tragedy was his eventual realization that his entire career was based on a flawed philosophy. As he left public life on the heels of the 2007 crisis, he gradually admitted a reality that he denied all his life: that markets were not perfect self-regulators. Unfortunately, that was too late for the rest of us.

A close cousin of Confirmation Bias is something called Conservatism Bias. That’s the tendency to overweight base rate information relative to singular, new information. Both biases cause us to react too slowly to warning signs, because we are generally slow to discredit established patterns.

Illusory Patterns: “This is a New Era, and the old rules don’t apply.”

This bias is the exact opposite of Confirmation Bias; the delusion that some new convention has changed the fundamental rules of risk, and we don’t have to worry about the things that the dinosaurs used to worry about.

I can’t believe how many of these phases I’ve already lived though. I remember during the dot-com era, when professional investment advisers went on CNBC to tell us that PE ratios were no longer relevant in the evaluation of a stock. Before that, the same advisers noted that the invention of email had changed the very notion of productivity, and the economy no longer played by the same rules as it did before.

In every instance, including and especially the 2007 crisis, those who caused the most damage were the CEOs and high officials that believed that detractors were old fossils who “simply didn’t understand how things worked now.” And in every instance, it turned out that none of the fundamentals had actually changed. We had just gotten ahead of ourselves. We had gotten too clever.

Meet the new boss. Same as the old boss.

Keep Debt from Screwing with your Head

Knowing exactly how the mind evaluates risk and debt means that we can anticipate pitfalls and make better decisions.

1. Set up your rules before you need them, and don’t relax them.

The 2007 financial crisis would never have done such wide-ranging damange if Congress didn’t get rid of the Net Capital Rule; that rule kept the strict investment bank borrowing limit of 12 to 1. Ironically, the law that got rid of that safety measure was called the Financial Services Modernization Act. The name wreaks of Illusory Patterns: seeing some kind of New Era where none exists.

Many financial engineers see debt as the oil in the gears of the finely-tuned market machine. That metaphor couldn’t be more wrong. Debt isn’t oil, debt is nuclear fuel. It’s neither good nor bad; it’s something to be respected. It can generate a lot of power, but without strict controls in place it melts everything down. Rules like capital reserves and leverage limits are the controls. So establish personal rules like, “I will only carry a credit card balance in an emergency,” or, “I will never take out a piggy-bank refi on my house.” Do this well before you get into a situation of need, because once you’re in that situation, its very easy to think the rules are unnecessary.

2. Anticipate Mental Distortions

There’s a lot of power in simply realizing, “I’m probably not thinking about this realistically.”

My wife always bids me to remember two words when I’m at the Vegas blackjack table: “walk away.” I’m the king of enjoying a bit of a hot streak, and then playing way too long after the streak has gone cold. When I’ve lost my first two or three after a good hot streak, I’m still ahead, and I have a burning desire to keep going. Somewhere in the reptilian parts of my brain, I believe that the hot streak I experienced up to this point will continue forever. That’s the greed talking.

In intense risk-management situations, we have to keep perspective. It may seem like a loss if others make more than you. That’s exactly how Lehman Brothers felt, right before the end. It’s far better to admit that your situation is screwing with your mind, and not risk your total downfall.

3. Do not take “below the waterline” risks.

If a warship take a hit above its waterline, it’s damaged, but it’s not sinking. But if it gets punctured below the waterline, it’s probably done for. Risk management, in all it’s complexities, usually comes down to one fundamental question: if the worst happens, would I recover? Would I get hit above the waterline, or below?

It’s very easy to take “below the waterline” risks for granted when we think that the chances of major consequences are so remote as to be non-factors. But the Black Swan event comes sooner or later. The market will inevitably receive a major shock. So your decisions about risks cannot only account for fair whether, they have to account for crises as well.

Click here to see Part 1, on the pleasure and pain of debt.

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  • Learn what makes a business fragile, so you can avoid pitfalls that sink most founders.
  • Discover how to set up your business to use setback and stressors as fuel for growth.
  • Build an unstoppable business that uses resistance to grow like muscle!