Confirmation Bias part one
Central to the fields of both psychology and behavioral finance, cognitive biases describe the innate tendencies of the human mind to think, judge, and behave in irrational ways that often violate sensible logic, sound reason or good judgment. The average human – and the average investor – is largely unaware of these inherent psychological inefficiencies, despite the frequency with which they arise in our daily lives and the regularity with which we fall victim to them. While the complete list of cognitive biases is extensive, this article focuses on eleven of the most common tendencies, chosen for both their prevalence in human nature and their relevance to investing in the financial markets. The purpose of this article is to educate you on these psychological predispositions so that you can better recognize and overcome them in your own decision making.
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Anchoring
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Also referred to as focalism, anchoring is the tendency to be over-influenced by the earliest information presented to us when making decisions, thereby allowing oneself to be driven to a decision or conclusion that is biased towards that initial piece of information. This earliest piece of information is known as the “anchor,” the standard off of which all other alternatives are judged. Thus, subsequent decisions are made not on their own, but rather by adjusting away from the anchor.
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For example, in price negotiations over a used car, the first price offered by the salesman sets the anchor point, from which all subsequent offers are based. By offering an initial price of, say, $30,000, a used-car salesman anchors the customer to that price, implementing a bias towards the $30,000 level in the subconscious of the other party. Even if the $30,000 offer is significantly above the true value of the car, all offers below that level appear more reasonable and the customer is likely to end up paying a higher price than he or she originally intended.
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While the used car example may seem somewhat harmless, psychologists have captured the effects of the anchoring bias in other more significant settings. For example, researchers have shown that court decisions of judges can be swayed significantly by anchoring effects. In one setting, judges were presented with details of a court case and asked to award damages to the appropriate party. Some of the judges were provided with a low anchor (a low damage estimate) while others were provided no anchor. On average, damages awarded by judges who were given the low anchor were 29% less than those awarded by the non-anchored judges. In a similar study, judges were provided details of a case and asked to determine the duration of an appropriate prison sentence. The anchor given to the judges was set by rolling two dice on the table directly front of them. Even when the anchor was set completely randomly in this fashion and its source was witnessed by the judges, the study showed that their
sentencing decisions were still subject to the anchoring effect and biased when a high dice number was rolled.
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In a financial market setting, anchoring is at play anytime the estimates or expectations of another party are allowed to influence your own judgments. For example, if a price target for a stock that you are considering is set by a particularly vocal Wall Street analyst at $200.00, your own estimates for that security’s potential price movement can be easily swayed towards that figure, potentially blurring your clarity of thought, inflating your expectations and dragging you into a poor decision.
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Aversion to loss and the effect of the stay
First appeared by prominent psychologists Amos Tversky and Daniel Kahneman, the notion of loathing loss to human inclination indicates a preference for decisions that allow us to avoid losses over those that allow us to gain. Hating a loss, for example, means that the pain of a $ 500 loss is much greater than the satisfaction that it will get from a $ 500 gain. Numerous studies on aversion to loss commonly suggest that human perception of loss is twice the gain strength. This forms the basis of what is known as probability theory, and it is the concept of behavioral economics that describes the way people choose between potential risk alternatives. In essence, Prospect's theory shows that loss is more important than equivalent profit. On the graph, the value function of the Prospect Theory developed by Tversky and Kahneman forms the following curve, whose unequal form shows the unequal value of identical gains and losses:
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Aversion to loss is discussed at length not only in psychological studies of how humans make decisions, but also in economics. In economics, aversion to loss is a basic concept at work when looking at how individuals behave in risky scenarios. Since individuals prefer avoiding losses over making gains, loathing the loss causes us to avoid risks when assessing results with similar gains and losses.
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Hate of loss was first proposed by Kahneman and his colleagues in 1990 as an interpretation of a closely related concept known as the endowment effect. The endowment effect describes the human tendency to place more value on a commodity that we possess than we do on an identical commodity that we do not possess. Together, aversion to loss and the impact of the endowment violate the fundamental economic principle known as the Coase Theory, which states that "resource allocation will be independent of the assignment of property rights when trade is at no cost possible". Research has shown that even when the trade involves no cost, ownership still creates discrepancies in the perceived value between the parties due to the effect of the moratorium.
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For example, the researchers demonstrated the effect of the moratorium by distributing a cup of coffee to each study participant and then giving them the opportunity to sell or trade the cup for an alternative good (in this case, pens) of equal value. On average, the compensation that participants requested to dispose of the cup (their willingness to accept) was almost twice higher than the amount they were willing to pay for the cup (their willingness to pay). In only a few minutes, the participants who obtained a cup attributed the property to the object, which raised their awareness of its value. Another popular study on the effect of a moratorium found that the default sale price of NCAA Final Four basketball tickets was an average of 14 times higher than the participants' default purchase price. Even when it is completely fictional, the ownership (stopping) of tickets enhances its perceived value.
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By linking the concepts of aversion to loss and the effect of a moratorium again on financial markets, it is easy to see how these trends can affect an investor. A loss aversion has a clear effect on our risk tolerance before and after the transaction is executed. Besides other cognitive biases, our tendency to move away from loss can lead to denial where losses accumulate in a vulnerable position, for example, causing neglect of weak situations in an attempt to reduce their emotional impact. Likewise, if the endowment's influence leads us to place more value on security just because we feel a sense of ownership over it, that emotional attachment can lead to a vague judgment when it is time to sell.
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