A brief lesson in history
Humans (technically - all the species with the genus 'Homo') have wandered over earth for over 2.5 million years. We, the Homo Sapiens, came by around 300,000 years ago - 2 million years after the primitive humans.
We started developing some form of language about 50,000 years ago, agriculture about 10,000 years ago and writing about 5,500 year ago. The first form of stock markets appeared about 700 years ago. To put this in perspective, if we look at it in terms of length of the following lines, it looks something like the following.
What's all this got to do with rationality, you ask? Everything! We are who we are today because of evolution. The natural phenomenon which tinkers with the features of species, and propagates the 'survival of the fittest'. In our case it has led to the largest brains when compared to other species. This brain, which has evolved over millions of years, has enabled us to survive the unpredictable Savannah, stay in small herds, forage for food and shelter, fight and protect ourselves from animals often larger than us, make up stories and gossip, and even pray in times of danger. It is due to this evolution of the brain (alongside the physical evolution such as better eyesight, canine teeth etc.) over hundreds of thousands of years, that it is now 'wired' in a certain way. The wiring is what enables newborns to suckle for milk, and hold your finger tightly if you place it in their palm. This wiring, created and refined over millennia, is what maximizes our chance of survival in an otherwise harsh world we inhabited as hunter-gatherers.
Since farming however, about 10,000 years ago, our lives changed dramatically. For the first time people settled down, accumulated food, grew into larger colonies and cities, and then came industrialization, (and finally our topic of interest - financial markets only 700 years ago) leading into the world we live in today. A world which is drastically different from the African Savannah. And while this world has changed, we unfortunately (or fortunately?) haven't. While 10,000 years seems like a very long period of time, from an evolutionary perspective, it is insufficient for us as a species to evolve significantly. We are still wired to respond to the stone age stimuli, and this is what leads to what we call 'cognitive biases' today.
Cognitive Bias - a term coined by Nobel laureate Daniel Kahneman and his partner Amos Tversky, about 50 years back - is used to describe systematic errors, our flaws, in decision making and judgement. These biases are caused by heuristics or shortcuts which our brain takes when confronted with a problem. In most situations, particularly the ones before industrial revolution, these shortcuts worked well. Take, for example, a mother turkey, who looks for 'cheep-cheep' sound from her chicks to protect them. This is the only trigger which invokes her motherly protective instinct, and it works. A polecat is the natural enemy of turkeys, and the mother turkey goes into attack mode on seeing a polecat, even a fake stuffed one. However, if the same stuffed polecat is fitted with a speaker making 'cheep-cheep' sound, the mother turkey starts protecting it instead of attacking it. The 'cheep-cheep' sound is the shortcut which the mother turkey takes to protect her chicks. As you can appreciate, it is an effective mechanism, unless some scientist tricks the turkey. Similarly, our heuristics were generally applicable in the world we lived in, but in the new-world situations such as investing, these biases may cause an error in decision making, leading to expensive mistakes.
What are these biases
There are a large number of documented cognitive biases, and there may be many more which we are yet to discover. This article however, aims to introduce us to the topic of biases and behavioral finance, and I will restrict it to just a few examples. That said, I am sure each of these biases warrant a separate deep-dive, so do watch this space. Here are a few of them:
The Narrative fallacy: We have this great ability to fill-in the details when we have only partial information available - to deduce and infer the story. For instance, if we see a baby crying we deduce she must be hungry, or that she need a change of diapers. If we see a tiger, we deduce that it is dangerous and we should run. And as such, this aids survival. However, sometimes (nay often) we come to incorrect conclusions in our attempt at making sense of the world - and this is the narrative fallacy. We build stories to justify things simplistically - to try and make the complex world more coherent, when we really can't and hence shouldn't. 'The markets are up because people are expecting healthy inflation and hence growth', 'The market ended lower because of inflation fears'. Such are the headlines you read everyday, when in reality no-one has any clue as to why the market actually went up or down. We need to be cautious of creating narratives in our head, while taking investment decisions, and rather rely upon data and facts. We must realize that these narratives only help satisfy our need to simplistically model the complex world, but may end up making us poorer.
(Some may argue that the narrative fallacy is not a bias in itself, but an effect of a combination of biases including the confirmation bias, hindsight bias etc. So be it, the point is to be aware and consciously work against it.)
The Availability Heuristic: This is a bias which causes us to give an inordinately high weightage to the events or example that come to mind more vividly or more easily, as compared to their actual weights. Immediately after events such as plane crashes, kidnapping, nuclear accidents etc. we believe they are much more likely to occur or cause more damage than they actually would (and the continuous coverage by news channels magnifies the impact of availability bias). This leads you to behave irrationally - for instance choosing to travel by road rather than by plane, even though statistically road accidents are several times more probable than plane accidents. If offered a 'terrorist insurance' before boarding a plane immediately after a terrorist attack, or accident insurance after a plane or a train crash, we are more likely to purchase it than when it is not recent (even though the probability of a terrorist attack or a train wreck is unaltered). In investing - a recent news, let's say, of a machine breakdown / plant closure, or poor performance in one quarter, drives people to sell that company's stock, without assessing the impact of that in the larger scheme of things. Further, I believe, the availability heuristic is stronger when the news is negative rather than positive. Whenever you decide to act upon news, always consider its impact in the larger scheme of things, look at probabilities and base rates, and do not get swayed just by possibilities.
Anchoring Bias: This is the reason why most of us end up overpaying at flea markets / street bazaars - the sellers exploit this bias. They quote a ridiculously high number (of course, after evaluating and judging you in the first few seconds) and anchor you to that number. And unless you are aware of this tactic of theirs, you would negotiate with them at numbers slightly below their quote, when the price quoted is higher by over 100% their actual selling price to some other customers. Similarly, this is the reason we miss out on re-buying our winner stocks. We get anchored to the number we encounter first, our initial buying price, and consider number above that as overpaying for the stock in our mental accounts, irrespective of how much better the company performs as compared to our earlier expectations.
Loss Aversion: We feel more pain from losses as compared to happiness from equivalent gains. In fact, this has been quantified - we need, on average twice the amount of gain to compensate for a loss of a specific amount. This implies, if we were given a bet (or 10) of winning $110 or losing $100, on an unbiased coin flip - we would usually not take it up, despite us having learnt everything about 'expected values' and positive sum games. It would typically take us $200 gain to compensate for the $100 loss. This also explains why we don't really understand and act upon sunk costs - we don't want to give up on the amount invested in a particular product (or investment) despite the rational choice being pulling the plug, taking the loss and moving on - the sunk cost fallacy. A second order effect of this bias is the 'endowment effect' where we value what we possess much more than what we would actually pay to acquire it. For instance, if you had good seats for football world-cup finals (insert your favorite sport here) and of someone offered to buy it from you - the price you would ask for it would typically be significantly higher than (more than double) what you would be willing to pay in a similar situation.
Dunning-Kruger Effect: Leads to what is called as 'being a confident idiot'. This essentially is a bias where people of low ability (in a particular topic / area) overestimate their abilities much more as compared to experts on that field. When we are not good at a task, we don't have the capability to even judge how good we are at it. For example, in experiments, students who get the lowest grades are relatively much more confident about their good performance in a test as compared to the best performers. Or that is why amateur stock advisors are so confident about their picks as compared to experienced experts, who almost always think in scenarios. At this point I am sure you have some person's image floating in your head, however, it could as easily affect you as well. As Charles Darwin said:
"Ignorance more frequently begets confidence than does knowledge"
If you were given a choice between $100 right now vs. $110 four weeks from now - and if you choose $100 - you are impacted by Present Bias - the tendency which leads us to overweight near term benefits and take smaller immediate profits for larger future profits. Otherwise called 'Instant Gratification'. This is why people save less for future and indulge more today.
You are affected by the Gamblers fallacy if you are certain that a coin is going to land on Tails, because it has give you heads 5 times in a row.
People often say "I knew this was going to happen" when something goes wrong (though don't do much to prevent it from happening or profit from that foresight). For instance, after the 2008 recession, there were a number of economists claiming it was inevitable, and there were signs all along for over 2 years etc. They are all impacted by the Hindsight Bias.
If you were given 2 choices - a vaccine with a "1% failure rate" or a "99% success rate" - which one would you choose? While both the statements mean the same thing, majority people would choose the second option - influenced by 'Framing'.
As I mentioned earlier, the list could go on. These are just some examples to acquaint us with the topic.
How biases affect rationality
In economics (or life in general) we are expected to behave rationally. We are supposed to weigh all the available information, evaluate the costs and benefits, and behave in the most appropriate manner to maximize our self-interest. In reality these 'Econs' exist only in theory. We 'Humans' are not perfectly rational, and act under the influence of our biases and heuristics when we make decisions, as we have seen in the several examples above.
In fact, even the most trained professionals are not spared by their biases - for example the Judiciary. Consider the case of the judge deciding on granting parole to prisoners. The likelihood of getting parole was dependent upon whether the judges' tummy was full - and therefore upon the timing at which the individuals case came up for hearing. So much for unbiased law!
As investors, our biases play a huge role in the returns we make, and the risk we take. The fist step to overcome them is to be aware that they exist. Learn about them, and think about the contexts where they would apply. Once you are in situations when you make new-world decisions (which is very, very often), do take a few seconds to think about why you took the decision you took. Analyze it post facto, and get more acquainted with your own biases - and which ones are more dominant.
The next step is to put a process in place, which you will follow to take decisions. Something which will prevent the biases from getting in the way of rationality. While this process may be different for different individuals - some steps could include:
Writing down the investment rationale, and re-reading it
Looking for disconfirming evidence, which disproves your thesis
Adding an element of time in the process - to avoid impulsive decisions
Learning more about the company / business / industry as the case may be
Lastly, realize that to be human is to be biased (and therefore err). These biases are partly what make us unique, slightly flawed individuals - when eventually makes the world a much more interesting place to live it. Without this irrationality, we would probably be living in a cold, predictable, boring world. You may probably think I am contradicting myself here by putting this in a blog called "Investing in Rationality" :-). The point I am trying to make is we need to understand and appreciate our biases, and try to overcome their effect in certain situations.
This is a topic which has fascinated me for some time now, and I continue to be amazed by just how irrational we are! With this article, I hope I was able to acquaint and inspire at least some of you to go down the rabbit hole of cognitive biases.
Until next time!
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