Important Cognitive Biases
I’ll try and highlight the most important Cognitive Biases that matter in so far as Behavioral Investing is concerned.
Mental Accounting refers to our inclination to categorize and handle money differently, depending upon:
- Where it comes from
- Where it is kept
- How it is spent
The idea of mental accounting was introduced by Richard Thaler.
The Man with the Green Bathrobe
There is a book called ‘How Smart People make Big Money Mistakes’ by Gary Belsky and Thomas Gilovich. The following is extracted from the book (emphasis is mine):
By the third day of their honeymoon in Las Vegas, the newlyweds had lost their $ 1,000 gambling allowance. That night in bed, the groom noticed a glowing object on the dresser. Upon inspection, he realized it was a $ 5 chip they had saved as a souvenir. Strangely, the number 17 was flashing on the chip’s face. Taking this as an omen, he donned his green bathrobe and rushed down to the roulette tables, where he placed the $ 5 chip on the square marked 17. Sure enough, the ball hit 17 and the 35–1 bet paid $ 175. He let his winnings ride, and once again the little ball landed on 17, paying $ 6,125. And so it went, until the lucky groom was about to wager $ 7.5 million. Unfortunately the floor manager intervened, claiming that the casino didn’t have the money to pay should 17 hit again. Undaunted, the groom taxied to a better-financed casino downtown. Once again he bet it all on 17—and once again it hit, paying more than $ 262 million. Ecstatic, he let his millions ride—only to lose it all when the ball fell on 18. Broke and dejected, the groom walked the several miles back to his hotel. “Where were you?” asked his bride as he entered their room. “Playing roulette.” “How did you do?” “Not bad. I lost five dollars.” This story has the distinction of being the only roulette joke we know that deals with a bedrock principle of behavioral economics. Indeed, depending on whether or not you agree with our groom’s account of his evening’s adventure, you might have an idea why we considered a different title for this chapter: “Why Casinos Always Make Money.” The usual answer to that question—casinos are consistently profitable because the odds are always stacked in management’s favor—does not tell the whole story. Another reason casinos always make money is that too many people think like our newlywed: Because he started his evening with just $ 5, he felt his loss was limited to that amount. This view holds that his gambling winnings were somehow not real money—or not his money, anyway—and so his losses were not real losses. No matter that had the groom left the casino after his penultimate bet, he could have walked across the street and bought a brand-new BMW for every behavioral economist in the country (and had enough left over to remain a multimillionaire). The happy salesman at the twenty-four-hour dealership would never have asked if the $ 262 million belonged to the groom. Of course it did. But the groom, like most amateur gamblers, viewed his winnings as a different kind of money, and he was therefore more willing to make extravagant bets with it. In casino-speak this is called playing with “house money.” The tendency of most gamblers to fall prey to this illusion is why casinos would make out like bandits even if the odds weren’t stacked so heavily in their favor. The “Legend of the Man in the Green Bathrobe,” as the above tale is known, illustrates a concept that behavioural economists call “mental accounting.” This idea, first proposed by the University of Chicago’s Richard Thaler, underlies one of the most common and costly money mistakes: the tendency to value some dollars less than others and thus waste them. More formally, mental accounting refers to the inclination to categorize and handle money differently depending on where it comes from, where it is kept, or how it is spent.
All of us do something similar when we are gifted money on our birthday or we get a tax refund or with any windfall gain that we receive.
The Pain of Paying
We experience the pain of paying whenever we are required to settle our bills. Each of us suffers it in different degrees, depending upon whether we are stingy or a spendthrift. This bias is a directly related to the fact that we are Loss Averse.
It doesn’t take much for any of us to believe something. Once we have formed our belief, we tend to protect what we think. Confirmation Bias is the human tendency to search for, interpret and remember information in a way that confirms one’s pre-existing beliefs. We tend not to change our behaviour, even though the fresh evidence may, in fact, be contradictory to our opinions. We look for evidence that confirms our prior beliefs. In this way we aggravate our bias. When we are confronted with evidence that contradicts our beliefs, we have two choices: (a) change our opinions or (b) ignore or even discredit the new information. Nobody likes to be wrong, hence most of us choose (b). Moreover, any information that contradicts our beliefs is an assault on our ego, and we work hard to swat it away. If new evidence aligns with our pre-existing beliefs, we lap it up.
There are two commonly believed fallacies regarding Confirmation Bias, these are:
- Many of us tend to believe that Confirmation Bias happens only to others and not to us. Each of us suffers from Confirmation Bias, and for the most part, we are not aware that our inherent bias is active. We are under the mistaken impression that we have our Confirmation Bias under control, and more often than not we are wrong.
- It has been proved that our Intelligent Quotient (IQ) is positively correlated with the number of reasons that people find to support their side of the argument. In other words, individuals with high IQ’s are more susceptible to Confirmation Bias than those with low IQ’s.
Effects of Confirmation Bias
Cognitive Bias results in the following:
- It encourages homogeneity of thought and leads to poorer decision-making.
- We tend to gravitate towards others with similar viewpoints as ours and this happens even to lawyers, judges and scientists.
Remedies to Confirmation Bias
Just by being aware of one’s biases does not ensure that we can overcome them. The only way to escape from Confirmation Bias is by being actively open-minded. Being actively open-minded means looking out for and seeking diverse viewpoints and dissenting opinions. In other words, encourage viewpoint diversity. Viewpoint diversity is a situation where each person’s views act as a solution to someone else’s Confirmation Bias. Viewpoint diversity is the most reliable way to get rid of Confirmation Bias. Being mindful instead of being mindless is what it is all about. The Ted talk embedded below, teaches us how we can address our Confirmation Bias in a systematic manner.
Eli Pariser coined the term Filter Bubbles in his book of the same name, published in 2011. He used the term Filter Bubble to describe the process of how companies like Google and FaceBook use algorithms to keep pushing us in the direction that we are already headed. By collecting our search and browsing data as also our contacts, the algorithms can accurately predict our preferences and feed our Cognitive Biases. We would be better off, without the constant nudge that these algorithms tend to provide. Effectively, a substantial number of internet users are in Filter Bubbles.
Eli Pariser on Filter Bubbles at TED
The single largest drawback of Filter Bubbles is that it has encouraged motivated reasoning. In fact, the proliferation of motivated reasoning has made us soft targets in the world of online marketing. What is Motivated Reasoning?
Once we are in a Filter Bubble, we refuse to update our beliefs, or we are not led down that path (due to algorithms). As a result, we fail to update our priors; once an opinion is lodged, it becomes difficult to dislodge. As our pre-existing beliefs decide how we process information, these beliefs get strengthened, and since we are not looking for disconfirming evidence, our bias feeds on itself forming a vicious circle. In this way, our beliefs take on a life of their own, and our confirmation bias draws us more and more into our echo chamber. Once we are in our echo chambers, we assume that everyone else thinks like us; we are blind to the fact that our beliefs might be wrong. This irrational, circular information processing pattern is called motivated reasoning. In other words, informing and updating our beliefs has an undesirable snowballing effect on our cognitive function and our decision-making capability.
Base Rate Neglect
Meet Preeti. She’s thirty-one years old, single, outspoken, and very bright. In college, Preeti graduated in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice and participated in climate change demonstrations. Before I tell you more about Preeti, let me ask you a question about her. Which is more likely?
a. Preeti is a bank teller.
b. Preeti is a bank teller and is active in the feminist movement.
Answer is a, most people think it’s b
Bank tellers who are also feminists—just like bank tellers who either sing or are concerned with climate change – are a subset of all bank tellers, and subsets can never be larger than the full set they’re a part of. In 1983 Daniel Kahneman, winner of the of Nobel Prize, and his late collaborator, Amos Tversky, introduced the Preeti problem (illustrated above) to demonstrate what they called the “conjunction fallacy”; one of the many ways our reasoning goes awry. It is also known as the ‘Representativeness Bias’.
Correlation ≠ Causation
Sometimes we buy a stock because some expert on a television channel or some website recommended it. If the stock climbs higher, we conclude that the source is a good one. That is too hasty a conclusion to arrive at based on just one recommendation. To arrive at an opinion, we have to study all the recommendations over the last many years, something that almost none of us end up doing. Only then can we conclude whether the recommendation in question was the result of luck or was there some skill involved as well.
Case Study on Confirmation Bias – Theranos
In 2003, Elizabeth Holmes dropped out of college and founded a Theranos. It was touted as a medical technology company. Holmes promised to revolutionize health care with a device that could test for a range of conditions using just a few drops of blood from a finger prick. Holmes, who used to dress like Steve Jobs, was an attractive blonde and she managed to capture the imagination of many big-name investors. Theranos was valued at $9 billion, with a shareholder roster that boasted of the ‘whos-who’ of corporate America.
The story was too good to be true. John Carreyrou, an investigative journalist of the Wall Street Journal reporter exposed the $9 billion startup as a fraud. He went on to write a book on the expose, called ‘Bad Blood: Secrets and Lies in a Silicon Valley Startup’.
The humorist, Josh Billings has said:
“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
The more you know, the more you will think you know more even more than you actually do. Overconfident investors are forever buying and selling something, even though they know less than they think they do. Humans are known to be confident in all cases where the task gets harder and the odds get closer to 50-50. The road to investing hell is paved with overconfidence. The reason we don’t address our overconfidence is that admitting our ignorance undermines our self-esteem.
The Dunning-Kruger Effect: we are all confident idiots
One of the most fundamental characteristics of human nature is to think that we are better than we actually are. There is an inner con man within us and that inner con man is a big fat liar. Most of us think that as compared to the averages, we are better looking, better investors, better savers, better lovers, better drivers etc. Just remember that mathematically, when we talk in terms of averages, half the people will be below average and the other half will be above average. Yet, we find that roughly 75
One of the features of our confidence bias is that it has been shown that commitment increases our confidence levels. In other words, the moment we place the bet, the act of putting down money makes us even more certain that we will win. This is despite the fact that the odds may not have changed at all, before and after the act of ‘putting down money’ has taken place. As investors overconfidence and underperformance are positively correlated in the following ways:
- We always rate our opinions and estimates as being correct and those of others as inferior. We refuse to be ‘actively open-minded’ and rarely if at all do we seek disconfirming evidence.
- We always overrate our power over the unknowns over which we never have any control. Hence, we tend to get surprised when things don’t work out as we expected them to. It is such a paradox that our behaviour as investors is something that we can control, but we don’t even try and do that since we are supremely confident that we are fully in control of our behaviour.
- When comparing our performance, we cheat and don’t see the numbers for what they are. We tend to give excuses and end up blaming everybody else, except the man in the mirror. That is a manifestation of our overconfidence bias. We refuse to see reality for what it actually is.
Lastof all, we have a terrible time saying the words ‘I don’t know’. Humans are just not wired to say the three words ‘I don’t know’, but you’ll find great investors use it all the time. The more we know, the more we think we know even more than we do.
Net, net we are overconfident in our ability to overcome our overconfidence bias and all other biases that it results in! The combined effect of all of the above is that we end up taking risks that we shouldn’t take and inevitably that leads to under performance.
Martin Luther King Jr. was a black activist American civil rights leader who practised non violence and civil disobedience in the United States from 1954, until his death in 1968. In 1964 he won the Nobel Peace Prize for combating racial inequality through non violent resistance. With that back ground watch the video below:
Reasons for Overconfidence Bias
Messrs Brad M. Barber and Terrance Odean showed via their research that the Overconfidence bias is the result or combination of the following:
- Self Attribution Bias: Our tendency to take credit for our success and blame others if we fail.
- The illusion of control: Our belief that can control the outcome of a situation or event by our actions. In reality, for the most part, and in a majority of situations, we have no control over the outcome. But since we are under the mistaken impression (illusion) that we can control the outcome, it leads to complacent behaviour, which in turn causes a host of problems. Staring at stock prices is an example of an illusion of control; in reality, we have no control over what is essentially random. Another example would be so-called experts trying to predict the direction of the stock market. In other words, the ‘illusion of control’ is that uncanny feeling that we can exercise some influence over random chance events by our deliberate actions. For example, many of us feed our portfolios into some online tracking software and fool ourselves into thinking that by monitoring our portfolio in such a manner, we have some control over the returns.
- The illusion of control has been widely studied and researched. The following experiment was undertaken at Stanford University:
Researchers picked the names of stocks at random from the stock quotes. The volunteers to the experiment had a choice. Either they
(A) guess whether the stock will go up or go down on the next trading day
(B) guess whether the stock had gone up or down on the previous trading day (you are not allowed to look at the stock price)
Two-Thirds of the participants opted to take choose (A). Why? That is because of the fact that in the case of option (B) above, we feel that the outcome is out of our control and in the case of (A) we feel that we can somehow control the same. That is how the ‘illusion of control’ works.
As a result of the illusion of control bias, we feel that our decisions or choices are inherently better than the choices other people make for us. Illusion of control is very common among investors. The risk is that when we believe we are in control, it makes us much more invested in our beliefs, choices and actions. As a result, we remain oblivious to the consequences thereof until it is too late.
- Illusion of Knowledge: Since, we have a problem saying ‘I don’t know’, we do the next most stupid thing and that is to lie. We pretend to know more than we actually do. In some cases, the problem becomes chronic and at some point we really come to believe that we do, in fact, know more than new actually do.
Blind Spot Bias
Many of us are aware of behavioural biases, but we firmly believe that these affect others and not you yourself. Its a foolish way of thinking and its called a bias blind spot. The question is do we have a metaphorical ‘blind spot’ as well? In other words, if not an actual blind spot, a virtual one? Research proves that we in fact do suffer from blind spots. Watch the videos below:
Selective Attention Test
The Door Study
Remedies for Overconfidence Bias
The best way in which we can confront our overconfidence bias is to stand in front of a mirror and ask the following questions:
- Am I the truly above average investor that I think I am? If that is true, by how much am I better or worse?
- Are my returns the direct result of my analysis and decision-making? What is the rate of return that I can achieve over the long-term? How does my historical performance compare with my peers and the benchmark averages?
- Am I following the correct process when taking an investment decision or am did I just get lucky in spite of having a bad process? In other words, how much of my success or the lack of it is because of my process and how much of it is because of luck? In the investing world, the quality of the decision and its outcome are not always positively correlated.
- Do I really know as much as I think I know or am I lying to myself?
- Teach yourself to say ‘I don’t know’ and ‘I don’t care’. In this way, you can circumvent questions about macro-economics. Warren Buffett is famous for his quote saying that he has never taken an investment decision based on macro.
- At all times, keep asking ‘and then what’?
- Whenever you are faced with a question or have to opine on something ask yourself two questions: (a) is it knowable and (b) is it important? Build a ‘too hard’ pile for questions that cannot be answered based on these two and keep dumping things in the ‘too hard’ pile regularly; these are the stocks for which you can safely say that you don’t know neither do you care.
- When we prepare discounted cash flows we use discount rates and try and be conservative. Similarly, use a overconfidence haircut to trim all your estimates.
- Start writing a trading or an investing journal and fill it with all the details and your reasoning why you want to buy or sell the stock in question. Revisit your estimates after twelve months and check to see how accurate they were. Did you overestimate or underestimate the outcomes? You should not be looking at the stock price, you should be looking at whether your reasoning was correct. In other words, did the stock price rise or ebb for the reasons you thought it would?
- When we track our portfolios, we should be tracking not just what we own, but also what we sold and also the stocks that we passed up on after analysing them.
- Always remember that tying wrong is far worse than being wrong. Embrace your mistakes and rectify them. Learn from you mistakes. The failure rate in the investing world is roughly 60 percent.
- Always follow a rules-based process aka an investing checklist and don’t deviate from it. \
- Always ask the question ‘why’. Ignore the day news, remember that the news follows the market action and not the other way around and stop paying attention to forecasts.
Hindsight Bias, Availability Heuristic & Representative Heuristic
Hindsight Bias & Outcome Bias
In the words of Daniel Kahneman: ’Hindsight Bias makes surprises vanish. People distort and misremember what they formerly believed. Our sense of how uncertain the world really is never fully develops, because after something happens, we greatly increase our judgements of how likely it was to happen’
We always tell ourselves that we knew it was going to happen and that we foresaw events as they actually played out. This feature of our personality is called the ‘hindsight bias’. What is so bad about hindsight bias is that we lie to ourselves thinking that we knew what was coming and worse still, we refuse to learn from our mistakes. Hindsight Bias is also known as ‘the I knew it all along’ phenomenon. Its another cruel trick that our inner conman plays on us. Once we know the outcome of an event, we tend to look back and believe that we knew what was going to happen right from the beginning. In other words, we tend too incorporate, almost seamlessly, the new piece of information into what you already know. Take the example of bitcoin, almost every one will now claim that they knew it was going to crash. When we hear something, we automatically incorporate it into something we already know; in the process we distort and misremember what we formerly believed. Effectively, after the outcome of an event has taken place, we increase our judgment of how likely it was in the first place. Hindsight bias has a deleterious effect on us because once we believe (and we really do believe) that the past was predictable, it makes us even more confident in our forecasts about the future. Unknowingly, we are also distorting our memory which is highly avoidable.
While investing, after demonetisation took place in November 2016, most investors were skeptical about India’s economic growth. The stock market was taken by surprise and it corrected by roughly ten percent. Not many investors were willing to invest. Now after the market has gone rip by thirty percent, everyone and their great-grandmother claims that they always knew that, post demonetisation was a great time to invest. Its the ‘I-told-you-so’ or ‘I-knew-it-all-along’, phenomenon.
Closely related to the hindsight bias is the Outcome Bias, whereby we start judging the quality of a decision after the outcome is known. In Poker this is known as resulting.
Many times in investing it makes sense to just do nothing. Ironically, that is one of the most difficult things for humans. As someone has famously said: “All of humanity’s problems stem from man’s inability to sit quietly in a room alone.” This finding is called Action Bias and the initial research was done by studying the goal-keeping “Action Bias Among Elite Soccer Goalkeepers: The Case of Penalty Kicks”. The researchers made the case that just doing nothing i.e. not diving to either sides and standing idle was a more effective method for saving goals. In other words, the chances of stopping the ball were highest when the goalie stayed in the centre. Why then do goalies dive? The reasons attributed were (a) they want to show that they are doing something (social proof) and (b) the goalie genuinely feels that he can stop the ball by diving. In the event that a goal is scored with the goalie standing idle, the media would probably massacre him or her for inaction, even though it is scientifically proven that it is the best thing to do.
How is the above related to Behavioral Investing? It is exactly what happens in the investing world. Most money managers, seem to be buy and sell at the worst times, when, in fact, the best thing to do is to sit on your hands.