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Behavioral Biases

Cognitive vs Emotional biases


Cognitive biases result from faulty reasoning and may
be information processing, statistical or memory errors.
Can be moderated by education.
Emotional biases are result of impulse or intuition and
arise spontaneously with no logic or reason
Emotions cant be moderated so emotional biases may
be adapted

Cognitive Biases
Belief perseverance: tendency to cling to ones beliefs
irrationally or illogically due to statistical or information
processing errors.
Processing bias: how information may be processed or
used illogically or irrationally.

Cognitive: Belief perseverance


Bias 1:
You have invested in a security after careful research.
Now you come across a press release which states that
the company you have invested has problem with its
main product line. The next line states about a
completely new product that the company might debut
later this year. What will be your action?
a) Typically take notice of new product and research it
further
b) Typically take notice of the problem in main product

Bias 1:
You invested in a stock and it appreciated in value but
not for the reasons you predicted:
a) Since the company did well and stock generated
profit, I am not concerned. As the stock gave profits, it
confirms that the stock was a good investment
b) Although I am pleased, i am concerned about my
investment and will do further research to confirm the
logic behind my position.

Bias 1:
You decide to hedge inflation by investing in gold and
found a relation between gold values and inflation. After
3 months you realize that gold prices have risen but
inflation has not gone up.
a) You will just go with it as your investment has
appreciated
b) You will research about relation between gold and
inflation and determine why they are not correlating
and then decide whether to stay invested or not

Mind acts like a compulsive yes-man who echoes whatever you want to
believe.
We're all mentally lazy.
It's simply easier to focus our attention on data that supports our hypothesis,
rather than to seek out evidence that might disprove it.

Confirmation Bias
People tend to look for and notice what confirms their beliefs,
and to ignore or undervalue what contradicts their beliefs.
This behavior has aspects of selective exposure, perception,
and retention and may be thought of as a selection bias.
Reflects an ability to convince ourselves of what we want to
believe by giving more weight to evidence that supports our
beliefs and to ignore or modify evidence that conflicts with our
beliefs.
Information is considered positive if it supports their beliefs
and negative if it fails to support or refutes their beliefs.

Confirmation Bias: IN INVESTMENT


Consider only the positive information about an existing investment and ignore any
negative information about the investment.
Develop screening criteria and ignore information that either refutes the validity of
the screening criteria or supports other screening criteria. As a result, some good
investments that do not meet the screening criteria may be ignored; conversely,
some bad investments that do meet the screening criteria may be made.
Under-diversify portfolios, leading to excessive exposure to risk
Hold a disproportionate amount of their investment assets in their employing
companys stock because they believe in their company and are convinced of its
favorable prospects.

Confirmation Bias: How to


overcome?
Actively seeking out information that challenges your
beliefs.
Imagine that you have looked into a crystal ball and
have seen that your investment has gone bust. Next,
come up with the most compelling explanations you can
find for the failure.
Show your investment to another person you respect
whose ego isn't already invested in the decision. Ask: If
you didn't own this, would you buy it now? If you did
own it, would you sell it now?

Confirmation Bias: How to


overcome?
Run an imaginary portfolio alongside your real one.
There, you can buy or sell at will, with no risk to your
wealth.

Bias:2
Suppose you live in Nainital and you make a forecast:
I think it will be a snowy winter this year. Furthermore suppose that,
by mid-February, you realize that no snow has fallen. What is your
natural reaction to this information?
a. Theres still time to get a lot of snow, so my forecast is probably
correct.
b. There still may be time for some snow, but I may have erred in my
forecast.
c. My experience tells me that my forecast was probably incorrect.
Most of the winter has elapsed; not much snow, if any, is likely to
arrive now.

Bias:2
When you recently hear news that has potentially negative implications
for the price of an investment you own, what is your natural reaction to
this information?
a) I tend to ignore the information. Because I have already made the
investment, Ive already determined that the company will be
successful.
b) I will reevaluate my reasons for buying the stock, but I will probably
stick with it because I usually stick with my original determination
that a company will be successful.
c) I will reevaluate my reasoning for buying the stock and will decide,
based on an objective consideration of all the facts, what to do next.

Bias:2
When news comes out that has potentially negative
implications for the price of a stock that you own, how
quickly do you react to this information?
a. I usually wait for the market to communicate the
significance of the information and then I decide what to
do.
b. Sometimes, I wait for the market to communicate the
significance of the information, but other times, I respond
without delay.
c. I always respond without delay.

Conservatism Bias
Maintain prior views or forecasts by inadequately incorporating new
information.
Fail to modify beliefs and hence Overweigh initial beliefs about
probabilities and outcomes and under react to new information.
Consequences:
Maintain or be slow to update a view or a forecast, even when
presented with new information.
Opt to maintain prior belief rather than deal with the mental stress of
updating beliefs given complex data.
In investment it causes overreaction/under reactions in stock market.

Conservatism Bias: How to


overcome
Whenever new information arrives ask questions like,
How does this information change my forecast? What
impact does this information have on my forecast?
If an investor finds it difficult to process new data he
may seek professional help who can explain how to
interpret the data or possible consequences of an
action.

Who do you think is Rich?

Bias 3: Representativeness Bias


People tend to classify new information based on past
experiences and classifications.
People tend to classify thoughts and objects into
personalized categories.
This classification reflex leads to deception and draw
conclusions that are statistically insignificant.
It leads to two affects: Base rate neglect and Sample
size neglect

Bias 3:Representativeness Bias


Base Rate Neglect: categorize any information without
considering the base probability of its lying in a
particular category. Eg categorization of successful
stocks into growth stocks
Sample size neglect: a particular sample size chosen
may be inadequate to make conclusion. For eg. If an
industry leader has performed poorly someone may
consider the entire industry to go down.

Microsoft Word
Document

Representativeness Bias:
Consequences
Good companies are good stocks.
If leaders report impressive performance then all the
stocks in that sector start going up. For eg. If steel
industry fortunes seem changing and Tata Steel report
increased profits then all the stocks including junk and
penny stocks see a rise even if they have not reported
higher earnings.
In technology boom adding a dotcom would make
investors chase a stock.
If a big buyer/broker is buying a stock then investors
consider it as good investment.

Representativeness Bias:
Consequences
PSU stocks are considered subject to government
influence and have a negative market perception.
New sectors may be considered as fancy investments,
eg: ecommerce.
If investors made money in a couple of IPOs then other
IPOs become representative of profitable IPOs and
investors chase them. While bearish markets do not
help even good businesses to earn money.

Representativeness Bias:
Consequences

Representativeness: How to
overcome
Group investments into a category only after thoroughly
studying its characteristics and specific features.
Do not draw conclusions on basis of one or two
variables, or 1-2 recent years performance.

You buy a stock because you think its prospects are good. Then you
learn that the companys earning power will be hurting for the several
years in the future. In the meantime, the stock has fallen 20% from
your cost. You mind will now invent new reasons to hold on to the
stock. You will start thinking that this is just a temporary adversity, or
the drop in price has made it even a better bargain so you should buy
more, or you have new cash coming in which you can invest in new
opportunities so no point liquidating this position, or the company is
developing a new product line and that will surely result in resumption
of profit growth, or the company has become an attractive acquisition
target and will surely be acquired at a large premium to the prevailing
price, or blah blah blah you get the point I think.

Dan is getting nervous that the market has experienced


several consecutive days of losses and is getting
uncomfortable having experienced many market
downturns throughout his lifetime. Based on his past
experience he is subconsciously putting the recent
market activity into the category of a market trend.

How likely do you think you are of being involved in a


road accident when _______?
Scenario 1:you are driving
Scenario 2:you are a passenger
If given a chance to select lottery tickets number
yourself or given randomly what will you prefer?

Question 1: When you participate in games of chance


that involve dicesuch as Backgammon, Monopoly, or
Crapsdo you feel most in control when you roll the
dice yourself?
a. I feel more in control when I roll the dice.
b. I am indifferent as to who rolls the dice.

Question 2: When returns to your portfolio increase, to


what do you mainly attribute this turn of events?
a. The control that Ive exercised over the outcome of
my investments.
b. Some combination of investment control and random
chance.
c. Completely random chance.

Question 3: When you are playing cards, are you


usually most optimistic with respect to the outcome of a
hand that youve dealt yourself?
a. A better outcome will occur when I am controlling
the dealing of the cards.
b. It makes no difference to me who deals the cards.

Question 4: When and if you purchase a lottery ticket,


do you feel more encouraged, regarding your odds of
winning, if you choose the number yourself rather than
using a computer-generated number?
a. Im more likely to win if I control the numbers picked.
b. It makes no difference to me how the numbers are
chosen.

Illusion of Control Bias


It is a bias in which people tend to believe that they can
control or influence outcomes when in fact they cannot.
People perceive themselves to have more control than
they actually did.
Inferred casual connections or certainty in predictions
for the outcomes of chance events

Consequences
Illusion of control bias can lead investors to trade more
than is prudent.
Illusions of control can lead investors to maintain
underdiversified portfolios.
Illusion of control bias can cause investors to use limit
orders and other such techniques in order to experience
a false sense of control over their investments.
Illusion of control bias contributes, in general, to
investor overconfidence.

Overcoming the bias


Recognize that successful investing is a probabilistic
activity.
Recognize and avoid circumstances that trigger
susceptibility illusions
of control.
Seek contrary viewpoints
Maintain records of your transactions, including
reminders spelling out the rationale that underlie each
trade.

C:\monika\lbs\
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Suppose you make an investment, and it increases in value. Further


suppose, though, that your reasons for purchasing the stock did not
touch on the forces underlying its growth. How might you naturally
react?
a) I do not concern myself with the reasons a stock does well. If it
performs well, it means I did a good job as an investor, and doing well
makes me more confident about the next investment I make.
b) Even though the stock went up, Im concerned that the factors I
thought were important didnt end up impacting its performance. In
cases like this, I usually try to revisit the reasons that I bought the
stock, and I also try to understand why it succeeded. Overall, I think
Id be more cautious the next time around.

Suppose you are investigating a money manager for inclusion in your portfolio.
Your advisor suggests a large cap value manager for you. What is your natural
approach to examining the managers performance?
a. I tend to look primarily at a managers track record, comparing his or her
performance to some relevant benchmark. I dont concern myself with the strategy
that the manager employs. The results that a manager achieves are most
important. If returns impress me, then I will select that manager; if I see a
mediocre history, Ill pass.
b. I look at the returns, which are important, but I also look at the managers
strategy and try to determine what the manager was doing during the time frame
Im examining. In the case of the value manager, I will look, for example, at 2002
the manager was probably down, but by how much? Which companies did the
manager invest in at the time? Evidence of a sound strategy makes me more likely
to select this money manager.

Hindsight Bias
You didnt know it all along, You just think you did.
People may see past events as been predictable and
reasonable to expect.
It is based on the belief that outcomes that occur are more
readily evident than outcomes that did not occur.
They consider the things which have happened as being
predictable or inevitable.
Poorly reasoned decisions with positive results may be
described as brilliant tactical moves and poor results of a well
reasoned decision may be described as avoidable mistakes.

Consequences
Overestimation of degree to which a person predicted
the results of an outcome, thus giving oneself false
sense of confidence and future risky investments.
Unfairly assess money manager or investment manager

Overcoming Hindsight Bias


Be honest to yourself
Carefully record and examine your investment
decisions.
All investment managers may be evaluated w.r.t to a
relevant benchmark and peer groups.

Number of Doctors in India


9.36 lakhs
Tell the product of the following:
1x2x3x4x5x6x7x8
40,320

Husband and wife in a Departmental


store
Husband: Honey look this expensive suit that I wanted
to buy is on sale today. It was Rs.12000 when I saw it
last week. Lets see what is sale price?
Wife: There are so many suits on sale. Look around and
you may get a better one
Husband: Yes good idea. Lets look around(He looks
around)
Husband: I dont like any other suit. They are expensive
although on sale. This Rs.12000 suit is only for Rs.6000
on sale.

Husband and wife in a Departmental


store
Wife: in that range of 6000 there are so many good
suits. Come here.
Husband: I saw. I dont like any of them. They are not
worth Rs. 6000. If I am paying Rs.6000 I would rather
buy that suit. At least I know I am buying a bargain at
half the cost.
Wife: Ok. Go ahead and make it fast before someone
takes it.

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Conversation between Jal and his


broker
Jal: I need Rs 50 lacs urgently for my business. I have
some gold. I need to sell it. Can you help me with that?
Broker: why do you want to sell gold? Instead sell this
stock of Pentafour. You are making a good profit. Your
purchase price is as low as Rs. 150. Today it is Rs.1000.
Jal: Are you mad? I am losing in that stock. A couple of
months back it was Rs. 1800.

Two investors: Sarosh and Ketan


Sarosh: I bought this stock of Hughes software at
Rs.700.
Ketan: I feel you must sell it off. You have made a big
mistake. The fortunes of industry have changed.
Sarosh: I know but my cost price is Rs. 700 and at
present the stock is Rs. 540.
Ketan: So what? Take the loss. The way markets are
treating companies like this it may go further down.
Sarosh: Yes I will sell. I will just wait for the price to
come back to my cost of purchase.

Two investors: Sarosh and Ketan


Ketan: How do you know it will come? Moreover you
need to sell because the industry and company
dynamics have changed. Faste the better for you.
Sarosh: Yes I know that. I am just waiting for the stock
to touch Rs.700

Anchoring and Adjustment Bias:


Information Processing bias
People generally begin by envisioning some initial,
default numberan anchorwhich they then adjust
up or down to reflect subsequent information and
analysis.
Closely related to confirmation bias

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Consequences of Anchoring and


adjustment bias
Investors tend to make general market forecasts that
are too close to current levels.
Investors (and securities analysts) tend to stick too
closely to their original estimates when new information
is learned about a company.
Investors tend to make a forecast of the percentage that
a particular asset class might rise or fall based on the
current level of returns.
Investors can become anchored on the economic states
of certain countries or companies.

Consequences of Anchoring and


adjustment bias
Try to ask questions like:
Am I holding to this stock due to rational analysis or am
I trying to attain a price that I am anchored to like my
purchase price or some water mark.
Find the rational of any recommendation: is it
fundamental research or the stock crossing a value
anchored in your mind?

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