Michael O. AdairManaging Director, Senior Investment Consultant | 2018

Cognitive Errors: Heuristics & Biases

Cognitive errors are defined as basic statistical, information processing, or memory errors that cause a person’s decision to deviate from the rationality assumed in traditional finance.

Cognitive errors are defined as basic statistical, information processing, or memory errors that cause a person’s decision to deviate from the rationality assumed in traditional finance. These errors fall into two sub-categories: belief preservation errors (the tendency to cling to one’s initial belief even after receiving new information that contradicts it) and information processing errors (mental shortcuts).

The three major cognitive shortcuts that laid the groundwork of prospect theory are representativeness (belief preservation), anchoring (information processing), and availability (information processing). These heuristics influence our judgments, typically subconsciously, and can certainly bias investment decisions.

TYPES OF BELIEF PRESERVATION ERRORS

Representativeness

Representativeness, the first of the “big three” heuristics, is a cognitive shortcut that replaces a question of probability with one of similarity. In other words, rather than considering the objective chances of a scenario happening, individuals find it easier and faster to assess how closely it corresponds to a similar question. The representativeness bias further supports the notion that people fail to properly calculate and utilize probability in their decisions. Investors can fail to notice trends or extrapolate data erroneously because they interpret it as fitting their preconceived notions.

The most common mistake to arise from this heuristic is the conjunction error. This refers to when the probability of A&B happening is judged to be higher than the probability of A. For instance, after reading a brief character description of someone lacking imagination but being very analytical, individuals deemed such a character more likely to both be an investor and play jazz than just play jazz. They failed to realize that an investor who plays jazz is nested within the category of anyone playing jazz.19 In the markets, investors can encounter the conjunction fallacy when interpreting key indicators. Pointing this error out does not preclude people from falling prey to it again. Although they understand the basic calculating error, people are prone to making the mistake time and time again.20 What is even more concerning is that experts making high-stakes decisions make the conjunction error too. The failure to recognize nested scenarios affected nearly all economists, analysts, and professional statisticians—illustrating how difficult it can be to avoid this mistake.21

What follows are some additional examples of belief preservation errors.

Conservatism

Conservatism refers to the tendency to insufficiently revise one’s belief when presented with new evidence. In other words, it occurs when a person overweighs their prior view and underweights new information. The original information is considered to be more meaningful and important than the new information, even when there is no rational reason for this belief.22

In finance, conservatism can lead investors to under-react to corporate events such as earnings announcements, dividends, and stock splits.23

Confirmation Bias

One’s tendency to search for, interpret, favor, and recall evidence as confirmation of one’s existing beliefs is referred to as confirmation bias. For example, people tend to gather or remember information selectively, or to interpret ambiguous evidence in a manner that supports their existing position. Confirmation bias also manifests when people tend to actively seek out and assign more weight to evidence that confirms what they already think, and to ignore or underweight evidence that could disconfirm it.24

In finance, confirmation bias can lead investors to ignore evidence that indicates their strategies may lose money, causing them to behave to overconfidently.25

Hindsight Bias

Hindsight bias refers to when past events appear to be more prominent than they actually were, leading an individual to believe that said events were predictable, even if there was no objective basis for predicting them. Essentially, this bias occurs when, after witnessing the outcome of an unpredictable event, one believes they “knew it all along.”

Illusion of Control

The illusion of control occurs when people overestimate their ability to control events or influence outcomes, including random ones, even when there is no objective basis for such a belief. In finance, this bias may lead investors to underestimate risks and have greater difficulty adjusting to negative events.

TYPES OF INFORMATION PROCESSING ERRORS

Anchoring

The second of the “big three” heuristics, and one of the hardest to mediate, is anchoring, which occurs when people consider a seemingly arbitrary value before estimating a quantity. Merely repeatedly saying a number, or having it drawn at random, can influence the estimate of an unfamiliar value. Before answering mathematical survey questions, participants had to write down the last four digits of their phone number. When analyzing the results, researchers found a correlation between those who reported high numerical estimates and those who had “high” phone numbers and, vice versa, a correlation of low estimates and “low” phone numbers.26 A completely rational investor would easily discount the extraneous information, yet research indicates that these seemingly irrelevant factors play a role in our judgments.

A secondary troubling finding regarding the anchoring bias is how difficult it is to control. Even when people were told about the anchoring effect, they were influenced by it despite reporting that they had consciously disregarded it.27 Anchoring further defies standard economic theory because high monetary incentives do little to mitigate its effect. Even large cash rewards for accurate estimates were not enough to make individuals more careful with their value judgments.28

For investors, the anchor can even be the price of the stock at the time of purchase. Future investment decisions can be associated with that value. For example, if a stock price drops, an investor may wait to break even to sell despite other indicators suggesting that a rebound in price is unlikely.29 Regardless of how the anchor manifests itself, whether it’s the buy-price or the 52-week high, investors should remain objective in their strategies and allocations.

Availability

The availability heuristic demonstrates how ease of recall can make a phenomenon seem more likely to occur. Additionally, an easier to imagine scenario is perceived to have a higher chance of happening than one that is harder to imagine. As a result, individual differences arise and can lead to vastly disparate perceptions. If an investor saw their property value plummet after the housing market crash, that experience will influence their decision in future real estate investments. Although adjustment is possible if people are made aware of the bias, it is not a foolproof method.30

The availability heuristic can help explain speculative bubbles. As interest rises for a particular asset, the media reports on it more frequently, more conversations revolve around the subject, and speculation increases. This creates a self-fulfilling prophecy in which investors bolster their own expectations thanks to the exuberance surrounding the asset or commodity. The ease of recall fuels such speculation and consequently a downturn is perceived to be unlikely.

What follows are additional examples of information processing errors.

Framing

A framing bias occurs when people view or react to information differently depending on the context in which it was framed. For instance, whether something is viewed as a loss or a gain may depend upon the description of the scenario. When information is presented in a positive manner, people tend to avoid risk. However, when the same information is presented in a negative manner, they tend to seek risk. This is because, according to prospect theory, a loss is more significant than an equivalent gain, and a certain gain is considered preferable to a likely gain. Meanwhile, a likely loss is preferred over a certain loss.31

In investing, framing bias can lead to a lack of understanding about the risk of short-term market movements since headlines tend to focus on the negative, leading investors to fail to adequately process the positives that remain in place.

Mental Accounting

Individuals tend to take a bucket approach to forming portfolios, mentally segregating their assets in order to simplify them. For example, they may separate their safe investment portfolio from their speculative portfolio to prevent the negative returns that speculative investments may have from affecting the entire portfolio. However, despite the effort of separating the portfolio, the investors’ net wealth will be no different than if they had held one larger portfolio.32

BIASES IN THE MARKET

The aforementioned heuristics can all be applied to FAANG (namely Facebook, Apple, Amazon, Netflix, and Alphabet’s Google) stocks.33 The repetitive and popular coverage of these assets can give rise to the availability bias. Their past performance notwithstanding, the ease with which investors can recall the fundamentals of FAANG stocks compared to lesser known ones can bias asset allocations. The representativeness bias, on the other hand, can influence the generation and perception of benchmarks. When evaluating certain equities, investors may compare them to FAANG stocks and look for any similarities. In fact, many headlines on news sites already make these comparisons—judging a tech company based on how it measures up to Amazon.34 Since objective probability is hard to judge, the easier question of similarity takes its place. Although nearly every page of disclosures mentions that past performance does not predict future results, many investment decisions can be swayed by precedents and retrospection. Anchoring also mitigates the effects of objective evaluations because irrelevant values can impact decision-making. Therefore, understanding fundamentals and ensuring diligent research can help immensely with making better decisions. However, it is crucial to be cognizant of the effect extraneous information can have on behavior because expertise does not eliminate these biases entirely.33

Not unlike other shortcuts, heuristics can be advantageous in many situations. They are so pervasive because of how effective they tend to be. Unfortunately, occasional errors can occur, and in the world of finance and wealth management, those can be disastrous.

Cognitive errors are defined as basic statistical, information processing, or memory errors that cause a person’s decision to deviate from the rationality assumed in traditional finance.

Sources

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