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Cognitive biases plague us and make it difficult for us undertake adequate analysis
and make good choices so knowing about them is imperative if we are going to deal with them. This article identifies 10 such biases and how they impede us making the right investment choices.
So writes Bob Seawright (http://rpseawright.wordpress.com) in edited excerpts from his original article* entitled Investors’ 10 Most Common Behavioral Biases.
[The following article is presented by Lorimer Wilson, editor of www.munKNEE.com and may have been edited ([ ]), abridged (…) and/or reformatted (some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. This paragraph must be included in any article re-posting to avoid copyright infringement.]
Seawright goes on to say in further edited excerpts:
Below is my list:
1. Confirmation Bias
We like to think that we carefully gather and evaluate facts and data before coming to a conclusion – but we don’t. Instead, we tend to suffer from confirmation bias and thus reach a conclusion first. Only thereafter, do we gather facts and see those facts in such a way as to support our pre-conceived conclusions. When a conclusion fits with our desired narrative, so much the better, because narratives are crucial to how we make sense of reality.
2. Optimism Bias
Optimum bias is when someone’s subjective confidence in their judgments is reliably greater than their objective accuracy…[but the fact is that] we are only correct about 80% of the time when we are “99% sure.”
- 94% of college professors believe they have above-average teaching skills.
- 80% of drivers say that their driving skills are above average.
- 70% of high school students claim to have above-average leadership skills…
- 92% students said they were of good character and 79% [of them] said that their character was better than most people even though 27% of those same students admitted stealing from a store within the prior year and 60% said they had cheated on an exam.
- Venture capitalists are wildly overconfident in their estimations of how likely their potential ventures are either to succeed or fail.
- In a finding that pretty well sums things up, 85-90% of people think that the future will be more pleasant and less painful for them than for the average person.
3. Loss Aversion
We are highly loss averse. Empirical estimates find that losses are felt between 2 & 2.5x as strongly as gains. Loss aversion favors inaction over action and the status quo over any alternatives. Therefore, when it comes time for us to act upon the facts and data we have gathered and the analysis we have undertaken about them, biases 2 and 3 – unjustified optimism and unreasonable risk aversion – conflict. As a consequence, we tend to make bold forecasts but timid choices.
4. Self-Serving Bias
Our self-serving bias is related to confirmation bias and optimism bias. Self-serving bias pushes us to see the world such that the good stuff that happens is my doing (“we had a great week of practice, worked hard and executed on Sunday”) while the bad stuff is always someone else’s fault (“It just wasn’t our night” or “we simply couldn’t catch a break” or “we would have won if the refereeing hadn’t been so awful”).
5. The Planning Fallacy
…The “planning fallacy” is a corollary to optimism bias and self-serving bias. Most of us overrate our own capacities and exaggerate our abilities to shape the future. The planning fallacy is our tendency to underestimate the time, costs, and risks of future actions and at the same time overestimate the benefits thereof. It’s at least partly why we underestimate bad results. It’s why we think it won’t take us as long to accomplish something as it does. It’s why projects tend to cost more than we expect. It’s why the results we achieve aren’t as good as we expect.
5. Choice Paralysis
Intuitively, the more choices we have the better. However, the sad truth is that too many choices can lead to decision paralysis due to information overload. For example, participation in 401(k) plans among employees decreases as the number of investable funds offered increases. We are readily paralyzed by too many choices.
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6. Herding
We all run in herds — large or small, bullish or bearish. Institutions herd even more than individuals in that investments chosen by one institution predict the investment choices of other institutions by a remarkable degree. Even hedge funds seem to buy and sell the same stocks, at the same time, and track each other’s investment strategies. That affinity fraud (e.g., Bernie Madoff fleeced the Jewish community to which he belonged) is so common is definitive evidence of herding.
7. We Prefer Stories to Analysis
As noted above, narratives are crucial to how we make sense of reality. They help us to explain, understand and interpret the world around us. They also give us a frame of reference we can use to remember the concepts we take them to represent. Perhaps most significantly, we inherently prefer narrative to data — often to the detriment of our understanding. Keeping one’s analysis and interpretation of the data reasonably objective – since analysis and interpretation are required for data to be actionable – is really, really hard even in the best of circumstances. A corollary to this problem and to confirmation bias is what Nassim Taleb calls the “narrative fallacy” — looking backward and creating a pattern to fit events and constructing a story that explains what happened along with what caused it to happen.
8. Recency Bias
We are all prone to recency bias, meaning that we tend to extrapolate recent events into the future indefinitely. As reported by Bespoke, Bloomberg surveys market strategists on a weekly basis and asks for their recommended portfolio weighting of stocks, bonds and cash. The peak recommended stock weighting came just after the peak of the internet bubble in early 2001 while the lowest recommended weighting came just after the lows of the financial crisis. That’s recency bias.
9. The Bias Blind-Spot
[The above and other such]…cognitive biases plague us and make it difficult for us to make good choices… Knowing about them is imperative if we are going to deal with them. We would always be wise to factor in these biases when performing analysis and making decisions. Unfortunately, we all tend to share a “bias blind spot” — the inability to recognize that we suffer from the same cognitive distortions that plague other people. Here is a wonderful (both hysterically funny and achingly sad) example.[Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.]
*http://rpseawright.wordpress.com/2012/07/16/investors-10-most-common-behavioral-biases/
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