munKNEE.com Your Key to Making Money
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.
_____
Save time! Here are 4 ways to access the best articles on the internet!
Sign up for our FREE Market Intelligence Report newsletter (sample)
“Follow the munKNEE” daily posts via Twitter or Facebook
Set up an RSS feed: It’s really easy – here’s how
_____
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/
Related Articles:
Here’s my list of the most common errors investors make and some related maxims. Read More »
2. Value Investing: The Practical Application of Benjamin Graham and Warren Buffett’s Principles
While the average amateur investor may be excellent in their own career field, it doesn’t mean they know what to invest in, or how to pick stocks. In fact being very good at your field can give you the false sense that whatever stocks you pick or your broker picks for you must be good, because after all, you picked them and you picked your broker — and you’re smart so, no doubt, those stock prices will go up. Unfortunately, the smart and talented stock-picking neophyte is not investing at all but speculating. Words: 924
3. Follow Bob Farrell’s 10 Rules of Investing – or Suffer the Consequences
Individuals are long-term investors only as long as the markets are rising. Despite endless warnings, repeated suggestions and outright recommendations – getting investors to sell, take profits and manage…[their] portfolio risks is nearly a lost cause as long as the markets are rising. Unfortunately, by the time the fear, desperation or panic stages are reached it is far too late to act and I will only be able to say that I warned you [- unless you take the time to read, and study the contents of this article]. Words: 1945; Charts: 10; Tables: 1
4. THE 10 Most Dangerous Investing Mistakes
Protect your money by steering clear of these 10 most dangerous investing mistakes. Words: 716
5. Recognize These 7 Emotions Before You Buy or Sell an Investment
Since there is such a wide range of emotions, it might be helpful for you to do a ‘gut-check’ before you actually buy or sell any type of security. Knowing how you “feel” about investing might turn out to be just as important as knowing what you “know.” Words: 737
6. 10 Timeless Investment Rules to Survive This Stormy Stock Market
Rules may be meant to be broken, but with investing ignoring the rules can break you – especially now. Investment rules are tailor-made for tough times, allowing you to stick to a plan just when you need it most. Indeed, a rulebook is important in any market climate, but it tends to get tossed when stocks are soaring. That’s why sage investors warn people not to confuse a bull market with brains. Here are 10 rules to survive this stormy stock market. Words: 769
7. Don’t Invest in the Stock Market Without Heeding These “Rules of Trading”
I’m not going to candy coat it for you: making serious money in the stock market is a ton of hard work. It takes patience, savvy, and a certain level of market smarts – and the cold, hard truth is that if you don’t have them, the big boys will drain your portfolio dry. Unfortunately, those are the three areas that most retail investors need to work on the most. Otherwise, they will simply end up in a cat-and-mouse game where they are the mice. Don’t fool yourself for one second into believing that your “due diligence” can be done by watching a show or two on CNBC. It just doesn’t work that way but if there is one voice from the markets that should grab your attention every time you hear it, it belongs to Dennis Gartman, founder and author of The Gartman Letter. He’s sort of a guru’s guru. [Here is] a glimpse into how he views and trades the markets. Words: 106
8. 12 Books that EVERY Financial Advisor – and Investor – Should Read
Bill Ackman, founder of Pershing Square Capital Management, believes the following books are essential financial reading. Enjoy the summer! Words: 235
9. Portfolio Down? Apply These Wise Sayings to Successfully Rebuild It
When the stock market reaches extreme levels of distress, the average investor – particularly those who have done their own research and made their own investment decisions – panic at seeing their savings diminish to such an extent. They often start questioning whether they should be making their own decisions and often their reaction is to salvage what is left and sell, sell, and sell some more. [Regretfully, that is not what one should do. Let me explain why that is the case and what you should be doing – NOW.] Words: 380
10. Words of Wisdom From the Most Brilliant Investors Ever
< noscript><img title=”investing4″ src=”https://munknee.com/wp-content/uploads/2011/08/investing4-90×65.jpg” alt=”investing4″ width=”90″ height=”65″ data-lazy-src=”https://munknee.com/wp-content/uploads/2011/08/investing4-90×65.jpg” data-lazy-type=”image” />There’s a bewildering amount of advice on how to invest…so it’s worthwhile, especially in today’s volatile markets, to take a look at what has actually worked, as opposed to what people claim works. We’ve collected some of the finest wisdom on markets from the most respected and successful investors, past and present. Words: 865
11. Understanding Systematic Risk, Modern Portfolio Theory and the Efficient Frontier
< noscript><img title=”investing4″ src=”https://munknee.com/wp-content/uploads/2011/08/investing4-90×65.jpg” alt=”investing4″ width=”90″ height=”65″ data-lazy-src=”https://munknee.com/wp-content/uploads/2011/08/investing4-90×65.jpg” data-lazy-type=”image” />Risk inherent to the entire market or market segment is referred to as systematic risk and modern portfolio theory says that a blend of investments has the potential to increase overall return for a given level of risk, and/or decrease risk for a given return that the investor is trying to achieve. The expected risk/return relationship is known as the efficient frontier. [If you have a portfolio of investments then you need to fully understand what all this really means and how you can apply it to your portfolio makeup to enhance returns under any circumstances. Let me do just that.] Words: 1325
12. Don’t Invest in the Stock Market Without Reading This Article First
History has shown that investors who stick to disciplined, fundamental-focused strategies give themselves a good chance of beating the market over the long haul and James O’Shaughnessy has compiled data that stretches back to before the Great Depression, back-tested numerous strategies, and has come to some very intriguing conclusions. [Let me share some of them with you.] Words: 1325