Watching an episode of The Wall recently made think cognitive biases in play during this game and how they mirror investing. Although the game seems simple, there are a lot of cool psychological biases going on just under the surface.

The Wall is a game show where contestants drop balls down a plinko board to either win or lose money. If they answer a question correctly, the board lights up green and they have a chance to win whatever amount the ball drops to. A wrong question will get money taken away from any amount they’ve earned up to that point. There are also random green and red balls that drop at certain points during the game.

Here’s where it get’s more interesting. The person who’s answering the questions in the isolation area can choose to sign a contract that will guarantee some money or rip up the contract and go home with the amount that is on The Wall. This wall amount could be millions of dollars or zero. You see how this can get interesting? What if there was $2 million on the Wall but the person signed a contract that game them $100,000 instead. They’d lose out on $1.9 million. The person in isolation signing the contract has no idea what’s on the Wall. The person dropping the balls with Chris Hardwick has no idea if their partner signed the contract or not until the very end.

Loss aversion refer’s to people’s tendency to dislike a loss more than they like an equivalent gain. Wall contestants may not know it but they dislike the red ball dropping into $250,000 slot more than they feel pleasure from the green ball dropping into the $250,000 slot. Losses hurt more than equivalent gains. This loss aversion was first discovered by famed scientists, Daniel Kahneman and Amos Tversky. The pair and their work are also a topic of The Undoing Project by Michael Lewis.

We also know about how much we loathe losses more than like gains. It’s about a 2:1 ratio. And it doesn’t just apply to money either. Humans experience the loss aversion with material things too: I’d hurt more if I lost my favorite pair of shoes than the joy I experienced when I purchased them. I imagine I’d have to lose them soon after the purchase for this to be true. No one cries over losing a 5-year old pair of kicks. You get the point.

Anchoring refer’s to people’s tendency to put too much emphasis on the first number or last number when making decisions. When the Wall contestant in isolation goes to make a decision as to whether or not they should sign a contract for a guaranteed sum, they don’t know the number on the Wall. The last number they saw was amount they won on round 1 which is designed to be a smaller amount than what’s possible – around $100,000 for example. The isolation person has some amount in their head, say $100,000. They also know they get $20,000 for each question they answer correctly (even though they’re not told if their answer is correct). This person has anchored in their mind $100,000. Any amount above that amount would be hard to turn down.

Of course, they may also have $12,000,000 in their mind if they’re focused on the max payout. I would argue that whatever number is more dominate as an anchor will determine their ultimate decision. The contestant with the $100,000 anchor in their mind will sign the contract worth more than $100,000 but not orders of magnitude more. The contestant with the $12,000,000 as an anchor will probably never sign the contract. They’re going for the big money.

Every investor has experienced anchoring too. For example, if I’m looking at a stock that sold for $60 per share yesterday and today it’s $40, I might erroneously think that the stock is now undervalued. But investing doesn’t work like that. Sure, the stock could be legitimately cheap and represent a good value but maybe not. Maybe the stock is still too high and it’s actual intrinsic value is $10 a share. The best way to avoid the anchoring bias is to think critically. Analyze the stock based on it’s earnings, revenues, or other real metrics. Don’t look at charts. This is easier to said than done. Everyone looks at charts, even people who know they shouldn’t.

Hindsight bias is the tendency to think the past was predictable after the event itself has occurred, even if there was no real way to predict it. Wall contestants are shown a series of answers and then asked if they’d like to triple up (at some turns), which means they’d drop 3 balls instead of just 1. If their partner gets the answer right, then 3 green balls are dropped down the plinko board and they have a chance to win 3 times as much. A wrong answer by their partner means 3 red balls are dropped and their cash amount is reduced. Contestants that triple up but then get the answer wrong will feel as though it was a mistake. But there was no mistake: they had little or no objective basis for determining the outcome. The answers that they saw prior to making the decision have a very low impact on whether or not their partner will answer it correctly. This is how the game is designed. The subsequent question could be anything.

Investing is a probability game. Decisions that investors make in hindsight appear to be right or wrong. Stock goes up equals “I’m so smart.” Stock goes down equals “I’m a dumb-dumb investor that should just put my money in an index fund.” Investors that have been at this game long enough realize both are not accurate. You’re not smart because you picked a stock that went up and you’re not an idiot for picking a stock that went down. It’s impossible to know that certain things prior to their occurrence. There are things you can control as an investor and things that are left up to chance. You choose to be diversified. You choose to not trade and invest long term. You can’t predict that a company will be hit with an accounting scandal and the stock will be cut in half. And it wasn’t wrong for you to pick the stock that got cut in half.

Humans all suffer from the same psychological biases. Those who know what to look for and the blind spots that avail themselves will make better decisions. It’s not always easy to catch the way your mind plays tricks on you. The goal is to make more rational and logical decisions based on knowing these biases. That’s what Munger did to make good investing decisions. As for The Wall contestants, it would be good to keep in mind that it’s a game of chance and that the decisions you make are not right or wrong. It’s all about probability.