Stocks don’t follow conventional economic theories. They follow socionomic theory. What is ‘
In the stock market prices reflect the current sentiment about the stock. And the sentiment is governed by the social mood or socionomics. Hence, when a stock goes up we want to buy more of it. And when it goes down we are in a hurry to sell. It is exactly the opposite of how it works with the traditional laws of supply and demand. In the normal world, humans don’t rush out to buy more when the prices go up. That is because we behave rationally. Not so in the stock market. In the stock market, we are emotional and irrational; moreover, we tend to herd. If one were to understand how socionomics works, it can enable us to acquire an ‘edge’. For that, we must first understand how Cognitive Biases work in our decision making. In this way, we can become rational in our investment process and not succumb to the laws of socionomics. In other words, we can acquire an investing edge by being aware and immune to the Cognitive Biases of other participants. It automatically enables us to take advantage of the biases in the market.
A cognitive bias is defined as a mistake in reasoning, evaluating or remembering, often occurring as a result of a deviation from our judgment and leading to irrational behaviour on our part.
It is widely believed that humans exhibit Cognitive Biases because of evolution. There are over 200 identified biases. Many of the biases overlap I.e. one bias leads to another. The cumulative impact of our biases is our irrational behaviour. Whereas all of us are born with Cognitive Biases, theses biases grow or ebb depending upon how they are nurtured. In other words, it is possible to identify the bias and address it in a constructive manner, if one so desires.
In the world of investing, the psychology of the investor and the psychology of the market are often not aligned with one another. In fact, it is this paradox that differentiates the investing greats from the rest of us. All in all, being aware of our Cognitive Biases is the first step towards rationality. To reiterate, in the market, it’s not you versus them, it’s you versus you. To improve upon our Cognitive Biases, the question we must ask ourselves is: ‘Can I handle the truth?’ Broadly our Cognitive Biases can be grouped under four heads in no specific order of importance:
- Attention: confusing or equating what is possible with what is probable. It is about being mindful rather than mindless.
- Conservatism: at times we prefer inaction over action or status quo over change and at times we are biased in the opposite way. We tend to get it backwards for the most part.
- Emotion: our tendency to conflate our moods or our feelings with reality.
- Ego: the tendency for us to be overconfident.
As prudent investors, we must learn never to use the word ‘never’. The reason is that, technically, anything is possible. Can the Nifty 50 hit a level of 20000 in 2019 (it is currently around 11000)? Many of us might think it can never happen. That’s the wrong way of thinking about it. We must learn to accept that in the realm of possibilities, it can happen. The question we must ask ourselves: how probable is it? In other words, we must focus on probabilities and not on possibilities. In addition to the word, ‘never’ there are many other words that we must learn to avoid in order to combat our Cognitive Biases, these are: ‘always’, ‘forever’, can’t’, ‘won’t’, ‘will’ and ‘has to’. Another word that we constantly use is ‘when’. When are interest rates going to go higher (or lower), when will Brexit happen, when will oil prices fall etc. While investing, we must be more concerned with the direction of the change, not when the change will actually happens. The direction part matters far less than the when part. So the correct question to ask is: are interest rates headed higher or lower, are oil prices headed higher or lower. To reiterate, the direction of the change matters more than the quantum of the change or it’s timing. That is not to suggest that these two variables do not matter, just that they are subservient to the direction.
Change is the only unchanging feature of our lives. Yet, inherently, we resist change. To be fair, there are many situations in which maintaining a status-quo is actually the best thing to do. For example, sensible decisions around nutritious and healthy eating habits are best left unchanged over our lifetimes. In other words, one has to judge the elements of change and any ‘change for the good’ is one that must be embraced.
Extreme emotion is the enemy of good decision making. Being more thoughtful, slowing down the decision-making process, using a rules-based strategy and being more deliberative, enable us to manage our emotions in a more productive and profitable manner. Apart from the control our emotions have over us, the environment that we find ourselves in also plays a huge role in manner in which we control our emotions. Many of us might find it easier to control the environment we are in, than to control our emotions. In fact, studies show that our will power is a worse predictor of our behaviour than our environment.
There are only two states that we find ourselves in; we are either depressed or we are overconfident. While making a decision if we feel we are overconfident, we probably are. In the investing process when we diversify, we are acting with humility and accepting the fact that we have to spread the risk. Effectively, we are also accepting that we cannot predict what the future holds with any degree of accuracy. In terms of gender differences, women are much less confident than men and that automatically makes them better investors. Despite this, we find that the world of professional investors is male dominated.