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 reduction in the 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.
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.