Erroneous Assumption

Q There are four cups with symbols E, 4, K and 7. Each has a combination of a letter and a number. So, the cup with a letter on it will have a number below it and a cup with a number will have a letter below it. You are told that a cup with an E has 4 under it. Which of the two cups will you turn to verify this statement?

If you belong to the majority tribe, you would have picked E and 4. James Montier, author of books on behavioural investing and a member of the global investing firm GMO’s asset allocation team, asked this question to professional fund managers in the US, of whom an incredible 95% answered the same. Surprisingly, it is the wrong answer and the correct pair is E and 7. Puzzled? Let’s see the logic behind it. E was a clear pick but when you chose 4 you were trapped by what psychologist called the ‘self-verification bias’. The question said that cup E had to have a 4 under it and not neccesarily that 4 would have an E below it. K being a letter naturally gets rejected. So we are left with 7, which if it has an E under it, would prove the statement to be incorrect.

The reason why you misread is because your brain was busy looking for evidences that proved your initial hypothetical results correct. In other words, you interpreted the sentence in a way that suited your conclusion and overlooked the rest. In fact, empirical research proves that the bias is not just limited to searching for self-approving information but also how messages are being interpreted, remembered or being reproduced later.

Say you are looking for an insurance plan and decide to buy a unit-linked policy, as suggested by the agent. You will tend to read and remember articles that talk about them as a great savings-cum- insurance solution and having other benefits like insurance liquidity and flexibility. You may completely ignore negative information like the insurance part being costly (which is your primary requirement) or hidden costs, such as premium allocation, mortality charge, fund management charge, etc, being very high.

The pitfall is both deep and dangerous. Montier believes this tendency to be cognitive ability resistant. That is to say, it does not matter if you have sharp cerebral processes as it is a sort of an intrinsic reaction. Therefore, you would have to train your brain accordingly and make cautious efforts to curb it.

A solution is to be a cynic of your own logic. Sir Karl Raimund Popper’s concept of falsification outlines how to curb this tendency. He argues that the only way to test your assumptions is by finding disconfirming evidences against it. That is, if you feel a stock is right, first find reasons why it may be wrong or if you feel certain about a mutual fund, try investigating why it may drag down the portfolio.

Though the solution may not seem like a revelation, practicing it, can be one. After all, who is fond of finding flaws in one’s own judgment. But isn’t it better to dent our ego a little than cling to irrational ideas which may collapse any moment?