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Behavioral Finance Finance

Behavioral Finance Series Part III

SETTING THE CONTEXT

So, in the previous two posts in the “Behavioural Finance Series” I had provided a brief introduction on the topic of Behavioural Finance, its distinction from the Traditional Finance Perspective and covered an overview of different types of Emotional Biases. If you’ve not already gone over those articles here’s the link, Part I and Part II.

COGNITIVE ERRORS

Cognitive Errors arise due to faulty information processing, reasoning lapses, erroneous data, etc. They are relatively easier to curb or rectify as compared to Emotional Biases and can be divided into two categories, namely:

  1. Processing Errors:
    • Representation Bias
    • Conservatism
    • Hindsight Bias (I-knew-it-all-along!)
    • Confirmation Bias
    • Illusion of Control
  2. Belief Perseverance
    • Availability Bias
    • Framing
    • Mental Accounting
    • Anchoring Bias

Now, in this post, I’ll be covering the different types of Processing Errors. In a future post I would be explaining the second category of Cognitive Errors – Belief Perseverance errors.

PROCESSING ERRORS: REPRESENTATION BIAS

What is Representation Bias?

Representation Bias is when we assess the likely outcome of a particular scenario based on its similarity to a previously observed scenario. For instance, if you forget your spouse’s birthday, she might be pretty mad at you. Let’s say you’re really bad at remembering dates and forget her birthday the next year as well, what do you think your spouse’s reaction would be? Well, based on your past experience, you’d utilise heuristics to conclude that she’d probably be pretty angry at you this time around as well (you’re definitely not going to expect a pat on your back, right?)

A more formal definition would be Representation bias occurs through memory recall. When a decision maker has to analyse the options of a decision, he/she tends to recall a memory or experience that is similar to the present decision-making situation”. While Representation is a common mental heuristic we all use to make sense of our day to day activities, it gets quite complicated in case of making investment decisions.

What are the consequences of Representation Bias?

  • We might tend to overly rely on the accuracy of our initial assumptions (e.g. yield curve inversion most certainly predicts a recession over the next 12 to 18 months or wife gets angry when her birthday is forgotten), while this might be useful in some instances, it might lead to over reliance on rules of thumb. Thereby, we fail to question the accuracy of the initial assumption made, this is called Base Rate Neglect.
  • We might place a skewed amount of importance on new data, leading to short-term focus and failure to understand the longer term perspective. For instance, with the markets being shaken up by COVID-19 outbreak, we may tend to overemphasis the pitfalls of the financial system and over-weight the likelihood of a gloomy economic scenario going ahead. We might just be overlooking the solid investment opportunities present right now or worse, close out positions because of panic selling (sounds familiar?)

How do we overcome Representation Bias?

  • One way to curb the effect of Representation Bias is to systematically focus on a disciplined long-term outlook for your investment portfolio.
  • Evaluate if your sample data set is an accurate or good representation of the population of assets you’re analysing. (when the sample data is an inaccurate estimation of the population it’s called Sample Size Neglect)
  • Periodically assess the robustness of the assumptions you’ve made to establish your Investment Strategy.

CONSERVATISM

What is Conservatism?

Conservatism is when, we come up with a very reliable, rational investment decision initially and fail to update it going forward because the new information we come across might be too complex to process OR we might be too slow to adapt and in some cases might NOT WANT TO react and make any changes at all!

What are the consequences of Conservatism?

Let’s say you believe “Gold is King” and this decision was wisely made once a upon a time when all other possible investable avenues were too risky, too illiquid or inaccessible. But if you stick on to this notion, even with changing economic scenarios and investment backdrops, you’re basically losing out on all the golden investment opportunities (well apart from “Gold” that is!). This aversion towards change and failure to update our portfolios even when the data clearly demands change, would lead to an investor holding onto their positions for far too long.

How do we overcome Conservatism?

Now this bias, is relatively harder to rectify when the information available is too complex to process. However, a more generic approach towards reducing the impact of “Conservatism” would be a more spiritually inclined answer, that is, to be mindful about one’s thought processes and identify our personal blind spots which limits us from efficient decision making. Lookout for feedback from your trusted peers and don’t get defensive when their ideas don’t necessarily align with yours. Listening to different perspectives would open up your thought process to be more welcoming to making a rational change.

HINDSIGHT BIAS, CONFIRMATION BIAS AND ILLUSION OF CONTROL

Now to explain Hindsight Bias, Confirmation Bias and Illusion of Control I’m going to walk you through an intuitive example and explain how these biases might in some cases bundle up together.

“Our comforting conviction that the world makes sense rests on a secure foundation: our almost unlimited ability to ignore our ignorance.”― Daniel Kahneman, Thinking Fast and Slow

Interestingly, we find it easier to explain the past nonchalantly but end up struggling when asked to extrapolate our views about the future. When incidents take place or circumstances arise, we utilise mental shortcuts to make sense of the situation and end up connecting the dots backwards to past events. It almost seems like it was OBVIOUS all along! This is called the Hindsight Bias (also popularly called the “I-knew-it-all-along” effect).

Doesn’t the 2007-2008 crisis seem SO OBVIOUS now? The debt/income levels were rising faster than ever, the housing prices grew faster than the demand necessitated and the regulations around internal credit quality checks were weak. The bubble should have been a completely OBVIOUS scenario, yet somehow every large financial institution participated in the game of grabbing a larger chunk of the securitisation pie head-on with minimal worries about their downside-risk. This scenario seems so OBVIOUS right now, but it wasn’t so back then. Most of the institutions were too wound up enjoying their big buck deals and extrapolating the rising demand for subprime debts and sky-rocketing house prices as a consequence of a booming economy. They kept reaffirming their pre-existing notions and used every piece of positive news to confirm that they were riding the waves to unlimited wealth (this is called Confirmation Bias, sadly the wave was actually a Tsunami and later crashed on the banks of the world economy quite tragically). These institutions believed the reigns of the money making chariot were in their hands and had an Illusion of Control. They practised investment decision making as though everything was under control and there’s no room for error. Even as default rates started rising, the credit agencies kept issuing AAA rating to the junkiest junk bonds (again because of their own big buck deals ) thus reaffirming the Financial Institution’s belief about their investment decisions and their position of control. Anyway, fast forward to 2020, when discussing the world’s former financial crisis, you definitely must have passed a few comments on how those greedy financial institutions missed something so patent back in 08’, well you might have good-judgement but chances are (not to shoot down your confidence) that you might just be under hindsight bias, wherein the past seems so much easier to explain than the future.

How do we overcome these biases?

  • Illusion of Control: Maintaining a long-term view of the portfolio, along with a systematic record of factors that are out of your control as an investor.
  • Hindsight Bias: Maintaining a complete record of all your decision-making steps, would enable you to identify the past wasn’t as obvious as it seems and the future isn’t as easy to predict. This would also help us identify the mistakes made in the past and place corrective measures and checks going forward.
  • Confirmation Bias: Seek out contrarian views and seek out solid corroboration for your existing views to establish their robustness.

And that’s a wrap for this week! 🙂 Stay tuned for new articles every week, simplifying Finance for Gen A to Z.

Happy Learning,

Prarthana Shetty

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