12 Cognitive Biases that Prevent you From Being Rational
I like this article that’s been floating around on cognitive biases. As I liked to say, it’s in being wrong that we can learn to be right. Understanding your own failings through introspection is one of the best ways to learn. Understanding why we’re often inherently designed to fail at understanding certain things is a crucial stepping stone to cross over in this process.
Confirmation Bias – The tendency for people to favor information that confirms their beliefs or ideas. Investors and economists often fail to fully appreciate other views due to a narrow minded view of the world often resulting from what they think they already know.
Ingroup bias – the tendency to favor one’s own group. In investing and economics we see this in ideologies and particular strategies. Austrians favor those who believe their own thinking. Chartists dislike value investors. Often times, the strongest economists and investors are the ones who are able to move beyond this ingroup bias and explore the potential that other groups have something positive to contribute.
Gambler’s Fallacy - When an individual erroneously believes that the onset of a certain random event is less likely to happen following an event or a series of events. We see this in trading all the time. This is the belief that just because something has occurred in the past that it is more likely to occur in the future. The “trend is your friend” and that sort of thing….
Post-Purchase Rationalization – When one rationalizes past purchases after the fact in an attempt to justify past actions. Investors often learn about how a bad trade turns into an investment when they rationalize their past purchases. If you’ve been in the business for a while you know how destructive this can be.
Neglecting Probability – A total disregard for probability and mismanagement of decision making through disregard for the odds of certain events. Investors and economists often overweight this in both directions at times ignoring the odds of a very high probability event and more often assuming that a high probability event (based on a small data set) means something is likely to occur.
Observational Selection Bias – An observational bias in which you begin to believe certain things are occurring more commonly because you’ve chosen to observe their existence.
Status-Quo Bias - The tendency to reject change in favor of what exists and feels comfortable in the present. This is a problem plaguing much of public policy. A staunch skepticism of change leads us to constantly believe that anything other than the status quo must be bad.
Negativity Bias – The tendency to focus on bad news as though it is more significant than good news. A problem rampant in the investment world. This is often the result of a lack of diversity in views and the inability to believe that past positions may or may not be wrong.
Bandwagon effect - the herding effect where we feel more comfortable doing what many other people are doing. There’s supposedly less risk in doing what many other people are doing even if they’re all engaging in the same irrational behavior.
Projection bias – the tendency to project your own feelings and beliefs to the rest of the world in an effort to confirm that your own views are accurate within the grand scheme of things.
Current Moment Bias - Focusing on the present to the detriment of the future.
Anchoring Effect - The tendency to focus too much on something first presented to you leading you to falsely perceive the value or significance of all other things around it. Amateur investors often do this by believing that the nominal price of a stock matters when compared to another stock.
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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18 Comments
As I read these flaws, I was thinking how billions of people trust fiat currency issuers.
Amazing really.
how’s that hyperinflation coming along?
Current moment bias )
I find it more interesting to note that the IASB’s definition of hyperinflation starts at 25% per year, and is the foundation of my bet with CR.
http://www.nowandfutures.com/images/inflation_cpi_cppi1800on.png
No inflation in houses or rents or stocks or oil etc. either.
/sarc
That’s a great list if, for no other reason, than to give an investor (or person in general) a list of things to work towards avoiding or doing the opposite.
I diagree with everything above because it does not conform with my worldview!
Anyone interested in this topic will greatly enjoy Howard Marks’(Oaktree Capital Management) latest memo:
http://www.oaktreecapital.com/MemoTree/Ditto.pdf
This stuff is overused and a bit patronizing. Granted, there are these cognitive biases, but there is also the presumption that there exists a true “rational” way of doing things. This is highly presumptuous, especially when it comes to activities, such as investing, that require educated guesses about and unknown future. Modern finance arrogantly posits that there is a unique ‘rational’ way to go about investing for the future, but this has been proven wrong time and again.
In other terms, what may look like “cognitive biases” may be perfectly rational responses to an unknown and “unknowable” situation.
Excellent list describing human nature.
But do any of these cancel the fact that over the long term most people will strive for a better life through hard work, smart thinking, better technology and cooperation?
Ultimately, after everyone sorts though the effects that each of these cognitive biases has on their own investment decisions do they decide that long term investing is a failure?
Each of these biases is just noise when viewed from the long term.
Here’s an interesting video showing a panel discussion between Nassim Taleb and Daniel Kahneman on this topic:
http://www.youtube.com/watch?v=LjGl6bZF6zs
It’s about an hour long, but very interesting
Nassim Taleb! I’ve never heard of that guy before, but just last night another commenter here suspected (in jest) me of being him (I guess because I used some control theory engineering language?). I’ll take a look…
Well I should be clearer…it’s not a discussion about cognitive biases specifically, but rather alludes to them in light of the economic crisis, the role of banks, etc. There were other entertaining presentations from that conference, specifically from Dan Ariely of Duke University who discusses what he calls “predictable irrationality”…worth checking out
You should be clearer? … but this is your first comment here on this page “Anonymous.” Wait… are you Nassim Taleb? Or William Bedloe? Or are you referring to a different discussion?
It was me…sorry
Daniel Kahneman’s book “Thinking, Fast and Slow” is the definitive treatise on the topic of biases and overall psychology:
http://www.amazon.com/gp/product/0374275637/
Cullen, when I first saw the title of this article, I thought you must have been inspired by your interaction with some of the commenters here over the last 24 hours. Ha!
An overview of the whole area of cognitive biases, logical fallacies etc. that I did a few years in self defense.
http://www.nowandfutures.com/spew_tools.html