As much as people like to think of investing as a hard science, the discipline more often entails the soft science as well. One example is behavioral finance.
Investing requires understanding the emotional conduct of stock market participants and how such emotions would affect the overall market’s behavior. This article looks at one of the two behavioral biases common to market participants, cognitive errors.
Cognitive errors are a result of faulty reasoning which could be due to an improper or lack of understanding of analytical techniques. Unlike behavioral bias (to be discussed in the next article), cognitive errors can be moderated/corrected through better information, education and advice. Such errors can thought of as a “blind spot” or distortion in the human mind. Listed below are some of the cognitive errors frequently appear in stock market participants.
This bias occurs when individuals continue to hold on to a prior view and fail to adequately accept new information. For example, a market participant investing in an oil producing company. Implications of such bias could lead individuals unwilling or slow to update their views on a particular stock and hence might hold out on an investment for too long in order to avoid the mental stress of updating the new information.
This occurs when market participants scout for new information or attempts to distort new information in order to support an existing investment thesis. They may consider positive information but ignore negative ones, hence holding onto investments longer than they should. An example could be having to observe patrons in a particular fast food chain when in fact, the growth of the business might already be deteriorating.
Illusion of Control Bias
This arises when an individual thinks they can control or affect outcomes when it is impossible to do so. An example could be that people who are allowed to select their own 4-D lottery tickets were willing to pay a higher price versus gambling on randomly assigned numbers. This gives gamblers the illusion of possessing control when none existed. Translating such behavior into the stock market could lead market participants in over-trading stocks and/or inadequately diversifying their portfolios (i.e. resulting in concentration risks).
Hindsight bias is a selective memory of past events or evaluation of what was knowable at that point in time. People may see that past events being predictable and reasonable to expect. They tend to perceive that the future is an extrapolation of what has happened in the past, ignoring the fact that the future holds uncertainties (common sense but clearly that’s not how the stock market perceives). This could lead participants to overestimate the rate at which they can correctly predict events, reinforcing an emotional overconfidence bias.
Investing is more often an art than science, investors should also take note of some of the cognitive errors which might impact their investment process.
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All views and opinions articulated in the article were expressed in Willie’s personal capacity and do not in any way represent those of his employer and other related entities. Willie does not own any shares in the companies mentioned above.