Blog Profile: The Psy-fi Blog, A Sideways Look at Psychology and Finance
June 6, 2010 Leave a comment
Some common behavourial bias he notes are
1) Overconfidence and Over Optimism (We think that we are of above average ability and therefore will make more money compared to the average investor.)
2) Hindsight Bias (a believe that the event that we witness earlier was predictable than before it took place, for instance we think we can sidestep a financial crisis.)
3) Loss Aversion (we tend to more risk averse when protecting gains compared to chasing our recovering our losses, for instance we poorly manage risk when our portfolio head south and we are quick to take profits when we see them.)
4) Regret (you regret missing a market surge? or have you ever regretted buying a particular stock that is going south?)
5) Anchoring (the mother of all biases and is hard to eradicate, it is represented by being fixated by some form of benchmark, for instance a particular valuation of property states price X and hence you never want to stray far from that selling price even though the market conditions are getting worse)
6) Recency Bias (a bias of over focusing on recent events, for instance you get overly pessimistic when recently market takes a pullback and miss the prevailing trend.)
67 Confirmation Bias (a bias where one seeks out other information that are aligned with their expectations, for instance you are bullish about a stock, you would then tend to search for other analysis that are also bullish about a stock)
Other interesting topics he brings forth includes cognitive biases, he poses some interesting questions in his article what is your financial IQ
(1) A bat and a ball cost $1.10 in total. The bat costs $1.00 more than the ball. How much does the ball cost? _____ cents
(2) If it takes 5 machines 5 minutes to make 5 widgets, how long would it take 100 machines to make 100 widgets? _____ minutes
(3) In a lake, there is a patch of lily pads. Every day, the patch doubles in size. If it takes 48 days for the patch to cover the entire lake, how long would it take for the patch to cover half of the lake? _____ days
notably only 17% of people in the study of the 3 qns above got all 3 qns correct. These questions points out that what that the first intuitive answer that comes to your head might not be the right one. Hence the immediate conclusions we make about our financial investments might also be incorrect.
Elsewhere he also points out that intelligence has nothing to do with how well you do or investment in the stock market. In addition, he cites in another research that finance professors do not invest better than the average layman. Also, experience does not necessarily make you a better investor.
Smart or Dumb, Makes No Difference
While it’s sort of encouraging to find that smart people who probably have better than average understandings of the ways markets work make the same mistakes as the rest of us and that untrained smart people are no better than anyone else at investing it does point up the psychological problems that underlie even relatively simple investing decisions. If clever people are confounded by these behavioural issues we can’t expect the huddled masses to do any better.
Separately, he also its ok to lose money and that we the probability that a buy and hold portfolio will face a period of 50% drawdown is 100%. He adds that people tend to underestimate the likelihood of bad stuff happening.
He also points out finance lessons in mass deception where he states:
That we’re born liars and our honesty is determined by how likely we are to get away without being caught and punished isn’t exactly a morally compelling message. However, being brutally realistic about ourselves is a better basis for making investment decisions than deluding ourselves with a bunch of numbers. Take a human being out of their social network and let them loose without moral constraints and what you have is a recipe for nasty things. But until financial institutions start taking financial lessons in mass deception from psychologists and taking less notice of economists engaged in their own mathematical arms race you’ll likely see this happen again and again. And again.
He also notes the complexity of the financial system now and says that:
Equally any set of economic theories or financial models or loudmouthed gurus that claim to be able to foresee the future are hopelessly lost in their own rhetoric. There is no designer, there is no plan, there is no predictability. There’s just stuff, which happens. The best we can do either is plan with a margin of safety or just get lucky.