It would take more than just a
couple of pages to outline all
the behavioral biases that can
affect our judgment when it
comes to investments.
Nevertheless, some of these
biases can be so damaging
that it is worthwhile to
highlight some of the more notable ones.
Herd mentality is one such bias that plays a very distinct role in the formation of market bubbles. Our decisions are apparently very much influenced by what others around us say and do. We don’t like to go against the “consensus” view, mainly because we fear being ridiculed. Keynes, also known for his investment prowess, used human psychology to guide him with his market bets. Using the analogy of a beauty contest, he argued that sophisticated investors would try to guess what the average investor’s perception towards a particular investment is in order to determine future value. This technique paid off because it allowed him to better anticipate the direction of markets.
The availability bias, another very common cognitive bias, describes our tendency of being more easily swayed by recent experience. The recent past plays a more significant role in influencing a person’s decision-making process than a more distant one. This explains why investors repeatedly and so easily get caught up in market bubbles, believing that “this time, things are different”. During the dot com craze of the 90’s, valuations reached absurd levels. In the last major housing bubble, investors maintained a voracious risk appetite despite the appearance of worrying “red flags”, starting with the sharp rise in subprime delinquencies. The media also reinforced the effect of the availability bias, by further fuelling the risk appetite of investors.
Anchoring, which is somewhat related to availability, refers to our tendency of remembering only the first segments of a pattern, which is then considered as being the “norm” for the remaining period. For example an individual who invests at the beginning of a bear market will expect the condition to persist and, as a result, adopt a more conservative approach (e.g. switching from equities to bonds). In other words, we are strongly influenced by what we experience at the start of a period and, through a process of mental simplification, tend to expect a continuation of the same conditions. Complicating matters is the fact that our response to an identical problem can differ widely depending on the way in which it is presented.
People have a tendency of being overconfident in their abilities on such diverse matters as stock picking or driving cars. Not being aware of such biases can lead to all sorts of costly mistakes. Hindsight bias describes our inclination to see events that occurred in the past as being more predictable than they actually were. With hindsight, it is always easier to identify and build a "narrative" around contributing factors that culminated to an event’s occurrence. Coming back to the housing bubble example, we now know that easy borrowing and absurdly lax mortgage rules led to excessive leveraging, which in turn served as catalysts for the bubble, culminating with a downturn. Very few saw this coming, of course, but there were plenty that made it sound like it was evident after the facts. Such biases give a false sense of security, the impression that we are in control when in fact we are not.
There is increased public awareness of the significant role played by cognitive biases on matters regarding investments. For the astute practitioner it is important to not only be aware of these biases, but also of their impact on the bottom line. Doing so can potentially eliminate or, at the least, lessen their damaging effects. Sometimes awareness may not suffice, however, as the biases are not always easy to control. Complex algorithms may provide a solution to this, but they also risk bringing in new problems. The right balance might just be a hybrid approach of humans and machines. After all, emotions can and do come in handy in certain circumstances, we just need to identify what those instances are.
Herd mentality is one such bias that plays a very distinct role in the formation of market bubbles. Our decisions are apparently very much influenced by what others around us say and do. We don’t like to go against the “consensus” view, mainly because we fear being ridiculed. Keynes, also known for his investment prowess, used human psychology to guide him with his market bets. Using the analogy of a beauty contest, he argued that sophisticated investors would try to guess what the average investor’s perception towards a particular investment is in order to determine future value. This technique paid off because it allowed him to better anticipate the direction of markets.
The availability bias, another very common cognitive bias, describes our tendency of being more easily swayed by recent experience. The recent past plays a more significant role in influencing a person’s decision-making process than a more distant one. This explains why investors repeatedly and so easily get caught up in market bubbles, believing that “this time, things are different”. During the dot com craze of the 90’s, valuations reached absurd levels. In the last major housing bubble, investors maintained a voracious risk appetite despite the appearance of worrying “red flags”, starting with the sharp rise in subprime delinquencies. The media also reinforced the effect of the availability bias, by further fuelling the risk appetite of investors.
Anchoring, which is somewhat related to availability, refers to our tendency of remembering only the first segments of a pattern, which is then considered as being the “norm” for the remaining period. For example an individual who invests at the beginning of a bear market will expect the condition to persist and, as a result, adopt a more conservative approach (e.g. switching from equities to bonds). In other words, we are strongly influenced by what we experience at the start of a period and, through a process of mental simplification, tend to expect a continuation of the same conditions. Complicating matters is the fact that our response to an identical problem can differ widely depending on the way in which it is presented.
People have a tendency of being overconfident in their abilities on such diverse matters as stock picking or driving cars. Not being aware of such biases can lead to all sorts of costly mistakes. Hindsight bias describes our inclination to see events that occurred in the past as being more predictable than they actually were. With hindsight, it is always easier to identify and build a "narrative" around contributing factors that culminated to an event’s occurrence. Coming back to the housing bubble example, we now know that easy borrowing and absurdly lax mortgage rules led to excessive leveraging, which in turn served as catalysts for the bubble, culminating with a downturn. Very few saw this coming, of course, but there were plenty that made it sound like it was evident after the facts. Such biases give a false sense of security, the impression that we are in control when in fact we are not.
There is increased public awareness of the significant role played by cognitive biases on matters regarding investments. For the astute practitioner it is important to not only be aware of these biases, but also of their impact on the bottom line. Doing so can potentially eliminate or, at the least, lessen their damaging effects. Sometimes awareness may not suffice, however, as the biases are not always easy to control. Complex algorithms may provide a solution to this, but they also risk bringing in new problems. The right balance might just be a hybrid approach of humans and machines. After all, emotions can and do come in handy in certain circumstances, we just need to identify what those instances are.
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