Tag Archives: system 1

WHY WE PREFER A WRONG MAP TO NO MAP AT ALL – Availability Bias

Posted on by under Behavioral Finance

We create a picture of the world using the examples that most easily come to mind. This is absurd, of course, because in reality, things don’t happen more frequently just because we can conceive of them more easily.

Unusual events (such as botulism) attract disproportionate attention and are consequently perceived as less unusual than they are. The world in our heads is not a precise replica of reality; our expectations about the frequency of events are distorted by the prevalence and emotional intensity of the messages to which we are exposed.

Our views for the world get changed as per available information, media news, etc. We create an expectation about events based on messages which can be distorted and can be far from reality. Media also uses these as exaggerate the news to enhance our viewership.

We majority focus on what is easily available or happens frequently in front of us rather than what can happen rarely or difficult to think. We have fear of death by car, plane or other accident rather than due to medical conditions. Because we have seen and read about many death through an accident.

Availability of the information will alter our decision and act. For example, 9/11 attack or COVID-19 will temporarily create a negative impact on the mind of travelers.

Protective actions, whether by individuals or governments, are usually designed to be adequate to the worst disaster experienced. We as a human being never accept the worst scenario can come. We get anchors with ongoing good period and keep thinking that this will remain forever until a disaster happens.

We all know that we should take healthy food, focus on diet, workout but we did not focus on it until COVID-19 has arrived. So now, the majority of people think about health and diet but still, few who are like dog tail, continue with junk.

Business – “The CEO has had several successes in a row, so failure doesn’t come easily to his mind. The availability bias is making him overconfident.”

Businesses also just not focus on what happens frequently but what can happen. So that they have to prepare for worst-case scenario also.

Investment – We attracted to invest in the stocks, sector which having an easy availability of information and that will lead to the bubble into particular stock or sector. We tend to avoid stock or sector which does not have enough information available though that stock or sector can be good.

When we have received continuous success then we will not generally think of meeting failure. Similarly, with investment, when people getting good returns from their investment, they forget about the inherent risk of equity investment.

When we have performed something recently, then the availability of those experiences goes everywhere with us and that mould our decisions. For example, when we have watched all parts of Sherlock Holmes in a few days, then we have the effect of it on our mind which attracts us to think suspiciously.

Rather on belief in instances, we should focus on statistics which can help us to make a wise decision.

We never prepare ourselves for the worst disaster until it arrives. This is the worst risk management example. When the market keeps rising, we think it will keep going to the upward direction, never fall. This anchoring effect of recently available information ties us to avoid risk. And we focus on risk after it comes to us. We need to focus on what can happen rather than what information is thrown to us. We have to think optimistic as well as pessimistic scenario when investing with all statistics. So that we can make a wise decision.

This entire series will be review with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.

LEAVE YOUR SUPERMODEL FRIENDS AT HOME – Contrast Effect

Posted on by under Behavioral Finance

We judge something to be beautiful, expensive or large if we have something ugly, cheap or small in front of us. We have difficulty with absolute judgements. So that we always decide on a relative basis.

When a person goes for a marriage meeting and wants to get selected in meeting then he should go with a below normal-looking friend or need to go alone rather go with a handsome looking friend. When a person looks nice comparatively then he has a higher chance of getting selected.

We cannot see small changes over a period so that Contrast effect make us blind through small changes.

Business – A product that has been reduced price from $100 to $70 seems better value than a product that has always cost $70. The starting price should play no role. Majority of the businesses uses this technique to attract more customers and increases their business.

Another technique used by businesses to sell 2 different products where one has some lower feature than the later product but the later product has slightly higher in price than a first product which attracts customers to buy the later product.

Investment – Initial days of my career, I have to communicate my research works to the retail clients. So, when I recommend the idea to them, many of them ask immediately a question that what was a 52-week high and low. If a stock is near to 52 weeks high then they do not prefer to invest in it. But stock either near to 52 weeks low or substantially lower than 52 weeks high then they prefer to invest. Also, if peers stocks have posted good return then people run behind which stock do not have performed well.

We should focus on what is a potential of stock from a current point rather than where the stock stands from its  52-week high and low.

Many investors focus on relative valuation i.e.; the company is relatively cheaper than its peers then that company has more chance to give a return. This may be correct. But we need to check that does that company has potential to meet the valuation of peers. It also can be possible that the inherent problems of the company tend to deserve such a lower valuation. So that we need to study all the company in an absolute manner, prepare positive & negative points of it. then have to look at does it undervalue or overvalue rather just compare it with peers valuation for decision. Any company should get valued on its inherent merit and demerit.

Another point is that when we have diversified our portfolio to a great extend then little changes in it does not affect our portfolio and that investment slowly loses our attention. So that we need to keep portfolio size to the extent that we can give equal attention to each holding of the portfolio.   

This entire series will be review with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.

DON’T BOW TO AUTHORITY – Authority Bias

Posted on by under Behavioral Finance

Authority bias comes when we put an extreme trust on authority, expert of a particular field. We just follow what they say and do not doubt on their opinions.

Whenever you are about to make a decision, think about which authority figures might be exerting an influence on your reasoning. And when you encounter one in the flesh, do your best to challenge him or her.

Business – Corporate has authority bias as founder, CEOs, directors pass an order and everyone follows it. If someone has viewed with proper data, facts and logic then also cannot challenge their order.

Successful business houses have the practice to invite better ideas from different employees group or department so that they get better insights for improving efficiency and operation.

Investment – Comeback to the stock market, we follow many of the celebrated investors, fund managers and we consider them as an authority. We do not argue on their opinion, investments thesis. We also tend to follow what they are doing. This behaviour is very rapidly affecting the majority of the participants. If Mr XYZ has bought ABC stock then the majority of us do not think anything and just run to buy ABC.

We should work on the preparation of process & checklist from listening, reading each guru, books etc. The process should be on what suits our temperament. It may be possible that few aspects may not be accepted by our process what authority says then we should not to do. Evolve from this bias can help us with becoming an independent investor rather than being depending on the authority.

This entire series will be review with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.

BEWARE THE ‘SPECIAL CASE’ – Confirmation Bias

Posted on by under Behavioral Finance

The confirmation bias is the mother of all misconceptions. It is the tendency to interpret new information so that it becomes compatible with our existing theories, beliefs and convictions.

We have some initial thoughts, opinion on anything and we try to collect information, evidence which supports our initial thoughts. And kick out evidence which does not support our initial thoughts.

We inevitably land in communities of like-minded people, further reinforcing our convictions – and the confirmation bias. We generally like people who have similar interest as of us. So, this association will again influence our decision making. We should have people in our life who can show us the other side of the coin rather keep supporting our views. Our mind does not accept opposite views so that we have to make it habituate our mind to accept the opposite idea. 

Business – When any management makes any kind of capital allocation decision then they will start collecting information which is supporting their decision. But we should check that management get succeed who have a focus on both optimistic as well as a pessimistic result of their decision.

We have mainly seen such behaviour among the management of cyclical industries. When the business cycle starts improving, then management focuses on increasing higher capacity, disturbing balance sheet, etc. rather improve efficiency and strengthening balance sheet to be ready for an upcoming burst in the cycle. Good management focuses on increasing capacity when everyone avoids so that they can take benefits when the cycle turns to be profitable.

Investment – When we have invested in a particular company, we try to find out evidence which supports our investment, which tells us that we will gain from this investment. When we are fully invested with all our money, we work on identifying evidence which tells us that market will do well and we will earn good returns. Reversely, when we have a huge fund to get invested, we work on collecting evidence that tells us market will go down and we will get good investment opportunities. Rather falling in confirmation bias, we should try to collect positive as well as negative evidence with a neutral mind decide to continue with original thoughts or to modify or change it.

Many a time, I have seen that people get emotionally attached to their investment so that they do not want to hear anything against their investment. We have to understand that our decision does not prove to be correct every time.

We should write down our initial belief and work on collecting disconfirming evidence to our initial belief. When we have confirmed as well as disconfirming evidence then we can make wise & rational decision without getting biased. When we have invested in a particular company then we should prepare a sell report on the same company. And if we have not invested then should work on collecting evidence which tells us why we should invest at the current point of time.

This entire series will be review with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.