One of the biggest mistakes an investor can make is ignoring or denying his or her biases.

The thought process through which most of us arrive at our view of the future is highly reflective of our biases. Given the unusually wide chasm between the optimistic and pessimistic cases at this time – and the impossibility of choosing between them based on facts and historical precedents (since there are none) – think about the role of bias.




Ignoring or denying your biases is a big mistake

One of the biggest mistakes an investor can make is ignoring or denying his or her biases. If there
are influences that make our processes less than objective, we should face up to this fact in order to
avoid being held captive by them.



Our biases may be insidious, but they are highly influential. 

Examples of "confirmation bias"

When I read articles about how difficult it will be to provide adequate testing for Covid-19 or to get support to small businesses, I’m pleased to see my wary views reinforced, and I find it easy to incorporate those things into my thinking.

But when I hear about the benefits of reopening the economy or the possibility of herd immunity, I find it just as easy to come up with counter-arguments that leave my concerns undented.


This is a clear example of “confirmation bias” at work:

• Once we have formed a view, we embrace information that confirms that view while ignoring, or rejecting, information that casts doubt on it. 
• Confirmation bias suggests that we don’t perceive circumstances objectively. 
• We pick out those bits of data that make us feel good because they confirm our prejudices. 
• Thus, we may become prisoners of our assumptions. (Shahram Heshmat, Psychology Today, April 23, 2015)

As Paul Simon wrote 50 years ago for the song The Boxer, “. . . a man hears what he wants to hear and disregards the rest.”



More examples of confirmation bias

• While I didn’t know the name for it, I’ve long been aware of my bias. In a recent memo, I told the story from 50 years ago, when I was Citibank’s office equipment analyst, of being asked who the best sell-side analyst on Xerox was. My answer was simple: “The one who agrees with me most is so-and-so.” Most people are unlikely to think highly of anyone whose views they oppose. So when we think about which economists we quote, which investors we respect, and where we get our information, it’s likely that their views will parallel ours.

• Of course, taken to an extreme, this has resulted in the unfortunate, polarized state in which we find the U.S. today. News organizations realized decades ago that people would rather consume stories that confirm their views than those that challenge them (or are dully neutral). Few people follow media outlets that reflect a diversity of opinion. Most people stick to one newspaper, cable news channel or political website. And few of those fairly present both sides of the story. Thus most people hear a version of the news that is totally unlike the one heard by those on the other side of the debate. When all the facts and opinions you hear confirm your own beliefs, mental life is very relaxed but not very enriching.

What’s the ideal? 

A calm, open mind and an objective process. 

Wouldn’t we all be better off if those things were universal?

Reference:

In investing, uncertainty is a given – how we deal with it will be critical. Read Howard Marks’s latest memo, in which he discusses the value of understanding the limitations of our foresight and “investing scared.”

https://www.oaktreecapital.com/docs/default-source/memos/uncertainty.pdf

Psychology and Investing: Confirmation Bias and Hindsight Bias

Confirmation Bias

How do we look at information?

Too often we extrapolate our own beliefs without realizing it and engage in confirmation bias, or treating information that supports what we already believe, or want to believe, more favourably.

If we have purchased a certain stock in a certain sector, we may overemphasize positive information about the sector and discount whatever negative news we hear about how these stocks are expected to perform.


Hindsight Bias

This is the tendency to re-evaluate our past behavior surrounding an event or decision knowing the actual outcome.

Our judgment of a previous decision becomes biased to accommodate the new information. 

For example, knowing the outcome of a stock's performance, we may adjust our reasoning for purchasing it in the first place. 

This type of "knowledge updating" can keep us from viewing past decisions as objectively as we should.

The 10 Mistakes Investors Most Commonly Make

All investors make mistakes. Otherwise, we'd all be millionaires. The trick is figuring out what our investing mistakes are -- and then trying to avoid them.

Meir Statman, one of the nation's leading experts in behavioral finance (the study of why people do irrational things with their money), has written a new book on the topic. In What Investors Really Want, published in October by McGraw-Hill, Statman goes a long way toward helping investors understand that many of their mistakes are caused by their own deep-seated emotions rather than, say, a company's unexpectedly poor earnings. 

In an interview with DailyFinance, Statman, a professor of finance at Santa Clara University in California, shared his top 10 errors that trip up average investors:

1. Hindsight error. "One of the most pernicious mistakes," Statman says. Because you can see the past clearly, you think you have a similar ability to tell the future. Hindsight error is common at the moment, Statman says, because many people are convinced they saw the crash coming in 2007. In reality, they may have thought a crash was possible, but they also thought the market might continue to zoom upward. Now, investors are convinced they actually saw the problem in 2007 but just didn't act on it. So, they believe wrongly that they can act correctly today. They think they know to sell at the precise moment the market is high and buy when the market is low. Based on their hindsight of 2007, portfolio diversification doesn't protect you from losses. But market timing rarely works, Statman says.

2. Unrealistic optimism. This is loosely related to overconfidence. Psychological studies have shown that when you ask people if they think they have the ability to pick stocks that will have above-average returns, men tend to say yes more often than women. "It's not because men are so smart. It's because men are unrealistically optimistic about their abilities," Statman says. This quality is great for job interviews, where you need to stand out from a crowd, but lousy for investing. "When you are unreasonably optimistic in the stock market, you are just readying yourself for an accident," he says.

3. Extrapolation errors. People expect that trends that existed in the recent past will continue in the future. For example, the fact that gold has gone up for the last 10 years has led many to believe it will always go up. But a study of a longer period -- going back to 1971 when President Richard Nixon ended the gold standard -- shows that gold hit a high of $850 an ounce in 1980 but was selling for $345 as long as 10 years later.

4. Framing errors. Often, Statman says, investing is like a game of tennis. People tend to see themselves hitting a ball against a wall, which seems easy. But that's the wrong frame. Investing is really like playing against another player -- when the other player is Warren Buffett or Goldman Sachs. Investors make framing errors when they see a CEO on TV talking up his stock. If it sounds good and you buy that stock, that's a framing error. Instead, you should be asking yourself: "Who else is watching this program, and what do I know that is uniquely mine?" "The answer is nothing," Statman says.

5. Availability errors. This refers to what information is available in your memory. Investors are often lulled into this error by investment companies. When you see an advertisement for a fund, it's almost invariably for one that has a four- or five-star rating from Morningstar. That way, the one- and two-star funds, with lackluster results, aren't available in your memory. "You say to yourself that there's a 90% chance I will be a winner," Statman says. Instead, look at results of entire fund families -- including the losers, not just the winning funds for a particular period, he says.

6. Confirmation errors. Investors tend to look for information that confirms their hypothesis, but they disregard evidence that contradicts it. Gold bugs, for example, constantly remind us that gold is a good hedge against inflation and a declining dollar. But when confronted with the evidence that gold actually fell price for an entire decade, they dismiss that as a different era because Ronald Reagan changed the rules of the investing game, and that problem won't be repeated.

7. Illusion of control. This is a sense investors have that they can make the market go up or down. It's like gamblers blowing on their dice before rolling. "These investors think they're riding the tiger, when in fact they're holding the tiger by the tail," Statman says. If you think you have a trick that can get the market to go your way, you better think twice: This is the illusion of control. "When you realize the market is actually a wild beast that can devour you, you try to put it in a cage," he says. A much safer approach.

8. Anger. This is an emotion we all know: It leads to things like road rage. In investing, you try to get even with the market. You do such things as double down or even sell all your stocks impulsively. "If you feel angry, it's better to wait 10 days before buying or selling, or you'll regret it later on," Statman says,

9. Fear. The other side of exuberance. When you're afraid, everything looks like a threat, and when you're exuberant, everything looks like an opportunity. Lots of investors are still afraid because of the market crash two years ago. They're sitting on the sidelines in cash earning no return or investing in things like Treasury bills, which aren't much of a bargain. "Risk and return go together," Statman says. "So, if you think the market is risky today, then you should also think the market has a good potential for high returns."

10. Affinity of groups. Also known as herding. You hear from your pediatrician that he's buying gold, so you think you should, too. But what do these people really know? What is the analysis based on? Statman notes that some herds are worth joining and some aren't. Many investors follow Warren Buffett's investment decisions and buy similar stocks. Since Buffett is usually a winner, perhaps that's a herd worth joining. But buying Internet stocks in 1999 or houses in 2005 based on what everyone else was doing was a horrible mistake.

Statman makes no grand conclusions in his book, but he does point out repeatedly that the average investor can rarely beat the market. Therefore, he recommends small investors put their money in index funds that provide average, if not spectacular returns -- and not catastrophic losses

"But if you like the pizazz of investing," he says, you might take a shot on individual stocks. Just be careful. 


By Charles Wallace

Posted 6:00AM 12/05/10
http://www.dailyfinance.com/2010/12/05/10-mistakes-investors-make/

Behavioural Finance

Behavioral Finance

By Albert Phung

Whether it's mental accounting, irrelevant anchoring or just following the herd, chances are we've all been guilty of at least some of the biases and irrational behavior highlighted in this tutorial. Now that you can identify some of the biases, it's time to apply that knowledge to your own investing and if need be take corrective action. Hopefully, your future financial decisions will be a bit more rational and lot more lucrative as well.

Here is a summary:

• Conventional finance is based on the theories which describe people for the most part behave logically and rationally. People started to question this point of view as there have been anomalies, which are events that conventional finance has a difficult time in explaining.
  
• Three of the biggest contributors to the field are psychologists, Drs. Daniel Kahneman and Amos Tversky, and economist, Richard Thaler.
  
• The concept of anchoring draws upon the tendency for us to attach or "anchor" our thoughts around a reference point despite the fact that it may not have any logical relevance to the decision at hand.
  
• Mental accounting refers to the tendency for people to divide their money into separate accounts based on criteria like the source and intent for the money. Furthermore, the importance of the funds in each account also varies depending upon the money's source and intent.
  
• Seeing is not necessarily believing as we also have confirmation and hindsight biases. Confirmation bias refers to how people tend to more attentive towards new information that confirms their own preconceived options about a subject. The hindsight bias represents how people believe that after the fact, the occurrence of an event was completely obvious.
  
• The gambler's fallacy refers to an incorrect interpretation of statistics where someone believes that the occurrence of a random independent event would somehow cause another random independent event less likely to happen.
  
• Herd behavior represents the preference for individuals to mimic the behaviors or actions of a larger sized group.
  
• Overconfidence represents the tendency for an investor to overestimate his or her ability in performing some action/task.
  
• Overreaction occurs when one reacts to a piece of news in a way that is greater than actual impact of the news.
  
• Prospect theory refers to an idea created by Drs. Kahneman and Tversky that essentially determined that people do not encode equal levels of joy and pain to the same effect. The average individuals tend to be more loss sensitive (in the sense that a he/she will feel more pain in receiving a loss compared to the amount of joy felt from receiving an equal amount of gain).
  

Table of Contents
1) Behavioral Finance: Introduction
2) Behavioral Finance: Background
3) Behavioral Finance: Anomalies
4) Behavioral Finance: Key Concepts - Anchoring
5) Behavioral Finance: Key Concepts - Mental Accounting
6) Behavioral Finance: Key Concepts - Confirmation and Hindsight Bias
7) Behavioral Finance: Key Concepts - Gambler's Fallacy
8) Behavioral Finance: Key Concepts - Herd Behavior
9) Behavioral Finance: Key Concepts - Overconfidence
10) Behavioral Finance: Key Concepts - Overreaction and Availability Bias
11) Behavioral Finance: Key Concepts - Prospect Theory
12) Behavioral Finance: Conclusion