In the Book “Nudge”, Authors Richard Thaler and Cass R. Sunstein, talk about two endpoints: hot and cold.

They write, “When Sally is very hungry and appetizing aromas are emanating from the kitchen, we can say she is in a hot state. When she is thinking abstractly on Tuesday about how much food to eat at dinner on Saturday, she is in a cold state. We call something “tempting” if we consume more of it in a hot state. None of this means that decisions made in a cold state are always better (Hint: Our post today will touch on this area). Sometimes we have to be in a hot state to overcome our fears about trying new things. Sometimes dessert really is delicious, and we do our best to go for it and hit the gym the next day. But it is clear that when we are in a hot state, we can often get into a lot of trouble.”

Do you recollect the post “Sign the Ulyssesan Contract before you Invest”?

Quick Refresh of that Post – Ulysses was on his journey home from the Trojan wars. The ship had to go through the Sirenusian islands. The islands were famous for being home to the Sirens, whose songs were so irresistibly seductive that seamen felt impelled to fling themselves into the waters, in an attempt to reach the Sirens. No seaman ever survived, so no living human knew the nature of the Sirens’ songs.

Ulysses wanted to be the first human to hear the songs and survive. He instructed his crew to fill their ears with beeswax, to block out the sound, and then tie him securely to the mast and to ignore his pleas to be released, should he do so. The plan worked. Ulysses heard the Sirens’ songs, the crewmen ignored his entreaties to be untied and when they were out of earshot, he gave a pre-arranged signal to take out the ear plugs and release him.

Ulysses knew the power and impact of arousal. He knew he would be in a hot state when he heard the song of the sirens. The post focused on what he did to survive this. Give it a read if you don’t recollect it. Read it even otherwise.

Now while Ulysses knew the power of arousal and cold/hot states (though I am sure he didn’t define it that way), most people in many situations do not correctly forecast a self-control problem because we underestimate the state of arousal. Authors Thaler and Sunstein write “This is something the behavioural economist George Loewenstein calls the “hot- cold empathy gap”, a concept whose main insight is that even if people realize that they behave differently when aroused, they underestimate the strength of the effect. When in a cold state, we do not appreciate the extent to which our desires and our behaviour will be altered when we are “under the influence” of arousal.

This causes some of the biggest mistakes in investing.

Consider a typical risk profile that an investor goes through. You might have gone through one. When you go through a risk profile, you are in a cold state. On the other hand, when the markets correct sharply and you hear the noise of doom and gloom, you are suddenly transported to a hot state. In this state you don’t remember the risk profile that you filled in. This is the last thing on your mind when everyone is screaming sell. If you were to do a risk profiling exercise at that point of time, your risk profile could be very different from the one done in a hot state.

At the same time, a hot state is not just when the stock market is going down; a hot state is also when the stock market is going up in one direction – UP (like it is now). Many who were conservative or super conservative earlier have suddenly become aggressive (though they still believe they are conservative). For them, conservative earlier meant 7%; now it is 12%.

The point here is that we underestimate the effect of a hot state on us.

Thaler and Sunstein write that every individual contains two semi-autonomous selves: a farsighted “Planner” and a myopic “Doer”. The Planner is trying to promote your long-term welfare but must cope with the feelings, mischief and strong will of the Doer, who is exposed to the temptations that come with the hot state. Some parts of the brain get tempted, and other parts are prepared to enable us to resist temptation by assessing how we should react to it. Sometimes the two parts of the brain can be in severe conflict – a kind of battle that one or the other is bound to lose.

So how do you win this battle and plug the hot cold empathy gap?

1. Self-Awareness is key. It’s not good enough to simply know that cold and hot states exist. Be aware of how they impact your decision making and understand the power of the hot state and its impact on you. Thus, label the states you are in. As Socrates said, “Know Thyself is the beginning of wisdom.”
2. Pre-commit to a Strategy like Ulysses’s did – Sign the Ulyssesan Contract before Investing.
3. If you are in a Hot State – Reset back to a Cold State by creating a gap between stimulus and your response. One of the ways is to speak with your Real Financial Professional. If you don’t have one, reach out to us by clicking on the following button.