Alternatives,  FIRE,  Life,  Stock Market

The Way We Think – 9 Cognitive Biases

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The market has bottomed, buy buy buy!!!

The market has more to fall, sell sell sell!!!

Hi guys! So those are the two main themes out there regarding the state of the market.

Those two messages are polar opposites of course, and just like Arthur Fleck, the last couple of months has left you confused, exhilarated, disturbed and above all, in shock.

So why are there two distinct views at the opposite end of the spectrum?

It’s because of the way we think.

Or more specifically, our cognitive biases.

WHOA! Is Joaquin Phoenix's Character Arthur Fleck NOT The Real Joker?
Cognitive biases personified.

Cognition

You see, most of us like to think we are rational people, in that we are in control of the investment decisions we make and the opportunities that present itself to us.

But we’re not.

Because there’s a myriad of cognitive biases which are hardwired into our brains.

So if you’re not care… what’s that? What are cognitive biases? Oh pardon me.

Cognitive biases are simplified thought processes that we all use. In simple terms, it is our subjective thinking.

Left unchecked, cognitive biases can lead us to irrational choices which can negatively impact our investments and finances.

For example…

Confirmation Bias

We tend to search for information which confirms our view of the world. Typically we also ignore information which doesn’t conform.

For example, shortly after I graduated from uni, I made numerous investing mistakes which culminated in my losing $40k… this has shaped my thinking from one of hyper-risk (power overwhelming), to one of conservatism (staying alive).

Stayin GIFs - Get the best GIF on GIPHY
Sorry, sorry, but the song gets me EVERY time.

It’s meant I place higher emphasis on bearish articles and information, as opposed to those espousing optimism. My returns could have been much higher in the past decade if I had been less conservative.

Everyone has confirmation biases, because our way of thinking is shaped by our past experiences. It’s just easier to see where new pieces fit into the puzzle we are currently working on, as opposed to an entirely new puzzle altogether.

These days, I try to balance out my approach, by deliberatly seeking points of view which are completely different to mine.

Anchoring Bias

We also use anchors or reference points when making decisions and evaluations.

It’s a trick the stock market serves up time and time again.

For example, say you have two companies ABC and XYZ.

ABC trades at $1, XYZ at $10.

ABC has 10,000 outstanding shares (or put in another way, each share entitles you to 1/10,000 ownership of the company).

XYZ has 1,000 outstanding shares.

Which company is “bigger” and hence more “expensive”?

The answer is, they are the same – because $1 x 10,000 gives you the total size (market cap) of ABC at $10,000.  $10 x 1,000 is the same $10,000 for XYZ.

Yet, in the marketplace, most people believe that ABC is “cheaper” at $1, hence has more room to “grow”, purely because of a lower share price!

Priming Bias

This is where we are influenced by what someone else has said to create a preconceived idea.

Nothing more better to highlight this than the media, and those who shout the loudest on the squawk-box.

Don’t believe everything you see…

It’s also why a lot of the time, media articles perpetuate into a self-fulling prophecy.

Just consider the infamous toilet-paper shortage of 2020. It started off as mere hoarding, then the media went into over-drive, and the rest is history.

But if we stopped and thought about it, a typical roll of toilet paper usually lasts a while, and most come in 12, 18, 24 sometimes 36 packs… surely we’d be able to get through our toilet paper in time for supplies to re-stock?

Positivity Bias

This is the view we take when we remember pleasant memories more accurately than unpleasant ones.

Personally, I see myself falling into this trap.

I am still holding onto some dud investments, despite the lack of growth prospects, and increasing opportunity cost, because “one day”, they’ll “come good”.

The problem with not ripping the bandaid off, is not ripping the bandaid off.

If it’s pointing to a dud investment – it most likely is one.

Negativity Bias

Similarly, just as we have positive influences, we also have negative ones.

Many people will be scarred from the first quarter of 2020.

It will likely affect their psyche for life, in terms of their approach to spending, jobs and investing.

Some researchers assert that negative emotions have an impact 3x stronger than positive emotions. And this is especially evident in the stock market.

For example, say you have $100, there is a 50-50 chance you will double your money or lose it all, what do you do? On paper, the odds are the same, but in reality most people would keep the $100 in hand.

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This is how we calculate market odds!

The emphasis on the downside kinda explains why there is so much chatter than markets still have more to fall.

Status Quo Bias

This one is where we have the tendency to stick to what we know and for things to stay the same. It’s why we shop at the same shops and buy the same brand of groceries.

We do this because it is easier to not do anything than it is to change.

It’s also why a lot of people (myself included) have been sitting in cash on the sidelines, whilst the market rallied 20% in the last month because we don’t know whether the market will be up or down tomorrow, next week or next month even.

It comes back to the old adage “a bird in hand, is worth two in the bush”. Sometimes though, getting those two in the bush ensures you won’t go hungry longer.

Survivorship Bias

This is when we focus on the people or things which have survived some form of process.

At the same time overlooking those which didn’t because of a lack of visibility on these failures.

Take Amazon and Apple for example – there are thousands of wannabe Amazon and Apple’s out there which have not succeeded… they just don’t get the airwaves.

But arguably, if all we are doing is looking into successes, we aren’t looking at the whole picture. We aren’t looking into the reasons why others have failed.

The trick is to learn what to do, and also what not to do.

Fail Long Jump GIF - Find & Share on GIPHY
Don’t do this.

Bandwagon Bias

As the name suggests, this is where people do something chiefly because others are doing the same (toilet-paper hoarding).

Think of it as “herd mentality” and “groupthink”.

In markets, it’s why the average investor sells at the lows and buys at the highs.

It’s ingrained into our DNA to stick together as a means to enhance the chances of our own safety.

That might be true 100,000 years ago, when sabre-tooth tigers and direwolves roamed the lands, but these days it’s all about being fearful when others are greedy and all that jazz.

Hindsight Bias

The “I-knew-it-all-along” bias. I think what you’ll see when the smoke clears from our battle with COVID-19, is the throngs of commentators who will come out and give explanations as to when the market bottomed, because it was so “obvious”.

Just like during the depths of the GFC in March 09, when peak fear was at its highest, late March was the point of the recent market bottom and seen a 20% rally in the space of a couple of weeks.

It’s so “obvious” now isn’t it? That was when central banks co-ordinated a global backstop to do “whatever it takes”. That was when the US federal reserve waded into buying corporate debt, and the US government announced $2,000,000,000,000 in stimulus packages.

But if it’s so obvious and the market will recover, why don’t we just go “all in” from here on out, and FIRE IN 3 YEARS BABY?!?!

Because nobody knows, and if they do, they either have a hidden agenda, or spouting bulldust – least of all those commentators.

Buy! Buy! Sell! Sell! signed Kal print – The Economist Store ...
How the stock market works.

~~~

This is why there are so many points of view regarding which direction the market will take.

It’s because everyone in investing has our own experiences of the markets and attitudes to risk.

Similarly we are all prone to the same errors in judgment.

The more aware of our own shortcomings, and acknowledge these tendencies we all possess, the more open and willing we’ll all be to make better investment decisions.

Don’t be blind to your own blindness!

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