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Cognitive Biases
Belief perseverance: tendency to cling to ones beliefs
irrationally or illogically due to statistical or information
processing errors.
Processing bias: how information may be processed or
used illogically or irrationally.
Bias 1:
You invested in a stock and it appreciated in value but
not for the reasons you predicted:
a) Since the company did well and stock generated
profit, I am not concerned. As the stock gave profits, it
confirms that the stock was a good investment
b) Although I am pleased, i am concerned about my
investment and will do further research to confirm the
logic behind my position.
Bias 1:
You decide to hedge inflation by investing in gold and
found a relation between gold values and inflation. After
3 months you realize that gold prices have risen but
inflation has not gone up.
a) You will just go with it as your investment has
appreciated
b) You will research about relation between gold and
inflation and determine why they are not correlating
and then decide whether to stay invested or not
Mind acts like a compulsive yes-man who echoes whatever you want to
believe.
We're all mentally lazy.
It's simply easier to focus our attention on data that supports our hypothesis,
rather than to seek out evidence that might disprove it.
Confirmation Bias
People tend to look for and notice what confirms their beliefs,
and to ignore or undervalue what contradicts their beliefs.
This behavior has aspects of selective exposure, perception,
and retention and may be thought of as a selection bias.
Reflects an ability to convince ourselves of what we want to
believe by giving more weight to evidence that supports our
beliefs and to ignore or modify evidence that conflicts with our
beliefs.
Information is considered positive if it supports their beliefs
and negative if it fails to support or refutes their beliefs.
Bias:2
Suppose you live in Nainital and you make a forecast:
I think it will be a snowy winter this year. Furthermore suppose that,
by mid-February, you realize that no snow has fallen. What is your
natural reaction to this information?
a. Theres still time to get a lot of snow, so my forecast is probably
correct.
b. There still may be time for some snow, but I may have erred in my
forecast.
c. My experience tells me that my forecast was probably incorrect.
Most of the winter has elapsed; not much snow, if any, is likely to
arrive now.
Bias:2
When you recently hear news that has potentially negative implications
for the price of an investment you own, what is your natural reaction to
this information?
a) I tend to ignore the information. Because I have already made the
investment, Ive already determined that the company will be
successful.
b) I will reevaluate my reasons for buying the stock, but I will probably
stick with it because I usually stick with my original determination
that a company will be successful.
c) I will reevaluate my reasoning for buying the stock and will decide,
based on an objective consideration of all the facts, what to do next.
Bias:2
When news comes out that has potentially negative
implications for the price of a stock that you own, how
quickly do you react to this information?
a. I usually wait for the market to communicate the
significance of the information and then I decide what to
do.
b. Sometimes, I wait for the market to communicate the
significance of the information, but other times, I respond
without delay.
c. I always respond without delay.
Conservatism Bias
Maintain prior views or forecasts by inadequately incorporating new
information.
Fail to modify beliefs and hence Overweigh initial beliefs about
probabilities and outcomes and under react to new information.
Consequences:
Maintain or be slow to update a view or a forecast, even when
presented with new information.
Opt to maintain prior belief rather than deal with the mental stress of
updating beliefs given complex data.
In investment it causes overreaction/under reactions in stock market.
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Representativeness Bias:
Consequences
Good companies are good stocks.
If leaders report impressive performance then all the
stocks in that sector start going up. For eg. If steel
industry fortunes seem changing and Tata Steel report
increased profits then all the stocks including junk and
penny stocks see a rise even if they have not reported
higher earnings.
In technology boom adding a dotcom would make
investors chase a stock.
If a big buyer/broker is buying a stock then investors
consider it as good investment.
Representativeness Bias:
Consequences
PSU stocks are considered subject to government
influence and have a negative market perception.
New sectors may be considered as fancy investments,
eg: ecommerce.
If investors made money in a couple of IPOs then other
IPOs become representative of profitable IPOs and
investors chase them. While bearish markets do not
help even good businesses to earn money.
Representativeness Bias:
Consequences
Representativeness: How to
overcome
Group investments into a category only after thoroughly
studying its characteristics and specific features.
Do not draw conclusions on basis of one or two
variables, or 1-2 recent years performance.
You buy a stock because you think its prospects are good. Then you
learn that the companys earning power will be hurting for the several
years in the future. In the meantime, the stock has fallen 20% from
your cost. You mind will now invent new reasons to hold on to the
stock. You will start thinking that this is just a temporary adversity, or
the drop in price has made it even a better bargain so you should buy
more, or you have new cash coming in which you can invest in new
opportunities so no point liquidating this position, or the company is
developing a new product line and that will surely result in resumption
of profit growth, or the company has become an attractive acquisition
target and will surely be acquired at a large premium to the prevailing
price, or blah blah blah you get the point I think.
Consequences
Illusion of control bias can lead investors to trade more
than is prudent.
Illusions of control can lead investors to maintain
underdiversified portfolios.
Illusion of control bias can cause investors to use limit
orders and other such techniques in order to experience
a false sense of control over their investments.
Illusion of control bias contributes, in general, to
investor overconfidence.
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Suppose you are investigating a money manager for inclusion in your portfolio.
Your advisor suggests a large cap value manager for you. What is your natural
approach to examining the managers performance?
a. I tend to look primarily at a managers track record, comparing his or her
performance to some relevant benchmark. I dont concern myself with the strategy
that the manager employs. The results that a manager achieves are most
important. If returns impress me, then I will select that manager; if I see a
mediocre history, Ill pass.
b. I look at the returns, which are important, but I also look at the managers
strategy and try to determine what the manager was doing during the time frame
Im examining. In the case of the value manager, I will look, for example, at 2002
the manager was probably down, but by how much? Which companies did the
manager invest in at the time? Evidence of a sound strategy makes me more likely
to select this money manager.
Hindsight Bias
You didnt know it all along, You just think you did.
People may see past events as been predictable and
reasonable to expect.
It is based on the belief that outcomes that occur are more
readily evident than outcomes that did not occur.
They consider the things which have happened as being
predictable or inevitable.
Poorly reasoned decisions with positive results may be
described as brilliant tactical moves and poor results of a well
reasoned decision may be described as avoidable mistakes.
Consequences
Overestimation of degree to which a person predicted
the results of an outcome, thus giving oneself false
sense of confidence and future risky investments.
Unfairly assess money manager or investment manager
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