Understanding cognitive bias or how to not let your brain sabotage you

Investing can be hard. Finding the right companies. Evaluating their long-term competitiveness. Gauging “market sentiment” and it’s position on the arc from ‘Greed’ to ‘Fear’. Choosing to enter / to exit / to just stay put.

Ken Heebner, who ran CGM funds from 1968 to 2016, was a legendary fund manager known for taking gutsy contrarian calls. For over a decade, his fund, CGM Focus returned 18.4% annually, beating the nearest comparable fund by 3.4%. Exceptional by any means. An analysis of investor returns in the fund, dollar-weighted returns taking into account capital flowing in and out, showed the typical investor lost 11% annually! Simply because the typical investor bought into the fund right after it had a strong run, then sold, when it saw a significant decline, the opposite of ‘Buy low Sell high’.

This means the worst investor returns were from one of the decade’s best performing fund. We are therefore, our own worst enemy.

Since the time behavioural economics as a distinct field of study was made popular by Daniel Kahnemann and Amos Tversky, hundreds of cognitive biases have been identified and labeled. The Better Humans blog has a neat graphic for these biases.

The Calm Investor | Behavioural Biases
Source: Better Humans

The bad news is that eliminating these biases is not really an option, since they are part of the same mechanism that has kept us alive over millennia. For investors, these biases (or mental shortcuts) sabotage our investment decision-making, getting us -11% returns from investing in funds doing 18%.

In a series of short posts (tagged ‘Investor Cognitive Bias’), we’ll briefly look at some of the most frequent mental traps we’re liable to step into, and steps to equip ourselves to minimise the damage.

The Calm Investor | Cognitive Bias

Investor Cognitive Biases: Neglect of Probability

In a classic experiment in 1972, participants were divided into two groups. Members of group 1 were told they would receive a small electric shock. Members of group 2 were told there was a 50% probability that they would receive a small electric shock. After this information was provided, researchers measured physical anxiety (heart rate, nervousness, sweating) shortly before starting.

The result: Absolutely no difference in the anxiety levels of the two groups. Puzzling.

Next, researchers announced a series of reductions in probability of getting shocked to group 2, from 50% down to 20%, 10% and finally 5%. There was still no difference in the anxiety level experienced by the group compared to group 1. When they announced an increase in the strength of the current, anxiety in both groups increased equally.

The anxiety level in group 2 finally did go down, when the probability dropped to 0%.

Neglect of Probability: We are wired to respond to the magnitude of an event and not to consider it’s probability.

The Calm Investor | Cognitive Bias Probability Neglect
Source: xkcd.com

How this bias sabotages investors

To our brains, a very likely and a highly improbable (yet possible) outcome are almost the same thing. This means we can’t intuitively differentiate between the 30% probability of 15% annual returns from a stable growing cash-generating company and the 1% probability of 300% return from an unknown small-cap. This explains the continued fascination with “experts” who’re highly visible in financial media, and like cryptically naming the odd stock, but never really get into the process they follow.

Dealing with this bias

To get better at incorporating probability into your thinking, start with a ‘base rate’ i.e. what are the chances of any given stock giving 300% results? (historical number of stocks that gave 300% / total universe of stocks). See how additional information now impacts that base probability. A company that’s just received exclusive rights to supply of a severely constrained raw material? a verified technological breakthrough that will disrupt an industry? a long-term government contract?

Iterating your assessment of likelihood of a particular outcome based on new information, while keeping the original base rate in mind is called Bayesian thinking, a powerful mental tool, and a must for every investor.

Up next in the series, how the scarcity error causes us to make the wrong investing decisions.

Further Reading:

Think like a Bayesian

3 thoughts on “Understanding cognitive bias or how to not let your brain sabotage you

  • September 13, 2017 at 2:59 pm

    Great read as usual. Agree with you on considering probability in non-extreme outcomes. But many thinkers like Nassim Taleb, WB and CM ask to ignore the probability when outcomes are so extreme that they are unacceptable. Ex. Russian roulette, LTCM (bets that can bankrupt you).

    Another good read is the samuelson’s problem which talks about considering probabilities in repetitive mutually exclusive events with asymmetric payoffs. Add to that Kelly criterion for understanding what amount of net worth to wager in such bets is pure gold.

  • September 14, 2017 at 12:16 am

    Thanks for the insight. Any links you could post to this material. Would love to read up, especially on Kelly criterion and Samuelson’s problem.

  • September 14, 2017 at 11:01 am

    These are pretty well known and researched concepts. You can google and find tons of material on both of them. I am sure you will be able to connect the dots once you read up on them.

What do you think?