The Emotional Purgatory Of Cognitive Biases – Part 1

Today and tomorrow we are being treated to a veritable triple whammy of central banker sponsored market perturbations. For an early sample of what to expect over the next two sessions look no further than the spasmodic whipsaw the USD/JPY just painted earlier this morning.

What you are looking at is price action fueled by pure human emotions. More specifically those spikes represent a mixture of fear and greed. Large opposing candles are usually produced by an attempt to anticipate and respond to already unfolding events. In this case market participants scrambled to adjust to more exotic BOJ policy changes in an attempt to be among the first to take advantage, or at minimum not to be left holding the bag. In my mind this is a complete waste of time unless you have direct access to considerable liquidity and are thus managing funds that exceed tens of millions. For everyone else the best policy is to simply stay out of the water and let the sharks gorge themselves until they’re fat and happy.

Since we’re talking trading psychology and the emotional purgatory most of us have to endure on an ongoing basis I thought it a great opportunity to launch a little mini series I call the ’emotional purgatory of cognitive biases’. To that end I will once again stand on the shoulders of giants, which means copying the most brilliant excerpts of known authors prolific in this area. One book you may enjoy is ‘The Art of Thinking Clearly’ by Rolf Dobelli. It’s rather comprehensive and there is a free summary available by Endika Aboitiz, Jr. which I will be heavily plagiarizing.

What I’ll be covering in this mini series will not always be directly related to trading. However I do believe that the untrained human mind represents a bona fide smörgåsbord of conflicting habits, beliefs, and opinions; some of it being personal and much of it owing to cultural or regional proclivities. And as such the act of self reflection or recognition in unrelated areas may yield to a more objective approach in others.

01. Survivorship Bias – Why you should visit cemeteries

Triumph is more visible than failure. You systematically overestimate your chances of succeeding. Guard against it – visit the graves of once – promising projects, investments, and careers. It’s a sad walk that clears your mind.

02. The Swimmer’s Body Illusion – Does Harvard make you smarter?

Professional swimmers don’t have perfect bodies because they train extensively. They are good swimmers because of their physiques. How their bodies are designed is a factor for selection and not a result of their activities. Female bodies advertise cosmetics and, thus, too many female consumers believe that these products make you beautiful. It is beautiful women that are candidates for cosmetic advertising. So before you take the plunge, look in the mirror and be honest about what you see.

03. Clustering Illusion – Why you see shapes in the clouds

The human brain seeks patterns and rules. It takes it a step further – if it finds no familiar patterns, it simply invents one. When it comes to pattern recognition, we are oversensitive. Regain your skepticism. If you think you have discovered a pattern, first consider it pure chance. If you see Jesus in your pancakes ask yourself, “If he really wants to reveal himself, why doesn’t he do it on CNN?”

04. Social Proof – If 50 million people say something foolish, is it still foolish?

In the middle of a concert, someone claps – suddenly the whole room joins you. Social proof is the evil behind bubbles and the stock market panic. A product is not better because is sells more.

05. Sunk Cost Fallacy – Why you should forget the past

Having paid for a movie is not a reason to stay through a bad one. “We have invested so much money in it. If we stop now it will all have been for nothing.”–the investment as a reason to carry on. The more you invest, the greater the sunk cost. This irrational behavior is driven by a need for consistency. Consistency signifies credibility. Rational decision-making requires you forget about costs incurred to date, no matter how much you have invested. Only your assessment of the future costs and benefits matter.

06. Reciprocity – Don’t accept free drinks

NGOs and philanthropist give, and then take. People have extreme difficulty being in another’s debt.
Reciprocity – a very useful survival strategy; a form of risk management. Without it, humanity and countless species of animals would be long extinct. The ugly side of reciprocity – revenge and retaliation. How many dinner parties have been endured in the name of reciprocity?

07. Confirmation Bias Part One – Beware of the special case

Facts do not exist because they are ignored. What the human being is best at is interpreting all new information so that their prior conclusions remain intact.

08. Confirmation Bias Part Two – Murder your darlings

Whether you go through life believing that “people are inherently good,” or “people are inherently bad,” you will and daily proof to support your case. Religious and philosophical beliefs are an excellent breeding ground for the confirmation bias. The Internet is particularly fertile ground for the confirmation bias. To stay informed, we browse news sites and blogs, forgetting that our favored pages mirror our existing values. Write down your beliefs – look for disconfirming evidence. Axing beliefs that feel like old friends is hard work but imperative.

09. Authority Bias – Don’t bow to authority

The Bible – you disobey a great authority, you get ejected from paradise. Authorities pose two main problems to clear thinking. Their track records are sobering – no one predicted the timing of the 2008 financial crisis, let alone how it would play out. Airlines have learned the dangers of the authority bias. Especially at risk – organizations with domineering heads. Lesser opinions are kept to themselves. When you are about to decide, think of what authority figure might be exerting an influence on your reasoning. When you encounter authority in the flesh – challenge.

10. Contrast Effect – Leave your supermodel friends at home

We judge something beautiful, expensive, or large if we have something ugly, cheap, or small in front of us. We have difficulty with absolute judgments. We don’t notice small gradual changes.

11. Availability Bias – Why we prefer a wrong map to none at all

We create a picture of the world using examples that come most easily to us. Things don’t happen more frequently because we conceive of them more easily. We travel through life with an incorrect risk map. We overestimate the risk of being victims of a plane crash than from dying from diabetes. We attach more risk to the loud and spectacular and less to the silent. “The Internet is particularly fertile ground for the confirmation bias. To stay informed, we browse news sites and blogs, forgetting that our favored pages mirror our existing values.”

We think dramatically and not quantitatively. Doctors and consultants practice what they know. We don’t have another solution, so we carry on with the incorrect tool. We prefer wrong information to no information. Spend time with people who are different from you – people whose experiences and expertise and outlook are different from yours.

12. The It’ll-Get-Worse-Before-It-Gets-Better Fallacy

Why “no pain, no gain” should set alarm bells ringing. If someone says that alarms should ring. Situations exist where things first dip, then improve. Not a religious zealot who believes that before we experience heaven on earth, the world must be destroyed.

13. Story Bias – Even true stories are fairy tales

Life is a muddle. We like to knit a jumble of details into a neat story. We want our lives to form a pattern that can easily be followed. We try on stories like we try on clothes. Stories attract us; abstract details repel us. Reality is distorted.

Take them apart – what are they trying to hide? Events that look connected today were not at the time. Events are not linear. Who is the sender? What are his intentions? What did he hide under the rug? What omitted elements may have been relevant? The real issues with stories – they give us a false sense of understanding.

14. Hindsight Bias – Why you should keep a diary

“I told you so.” Makes us think we are better predictors than we really are, causing us to be arrogant about our knowledge and consequently take too much risk. Keep a journal. Write down your predictions – compare. Read history – the diaries, oral histories and historical documents, not the compacted theories of textbooks. If you can’t live without news, read media from 10 years ago. You will see how unpredictable the world is.

15. Overconfidence effect – Why you systematically overestimate your knowledge and abilities

Experts suffer more from overconfidence than lay people. 84% of Frenchmen estimate they are above average lovers. 93% of US students estimated they are above average drivers. The return on investment in the restaurant business lies chronically below zero. They keep opening. Hardly any projects exist that are completed on-time and below budget. Those with direct interests have an incentive to underestimate the costs. Consultants, contractors, and suppliers seek follow-up orders. Even pessimists overestimate themselves – just less extremely. Challenge predictions.

16. Chauffeur Knowledge – Don’t take news anchors seriously

Two kinds of knowledge: Real knowledge – from time and effort dedicated to understand it. Chauffeur knowledge – from having learned to put on a show. Hard to tell the difference. From anchors, easy. From journalists, hard. Circle of competence – what lies within, you understand intuitively. What lies outside, we comprehend only partially.

Stick to your circle of competence. It does not matter how large the circle is so long as you know where the perimeter is. If you play where others have the aptitude and you don’t – you will lose. Be on the look out for chauffeur knowledge. How? True experts know the limits of what they know and what they do not know. They unapologetically keep quiet or say, “I don’t know.”

17. Illusion of Control – You control less than you think

People choose numbers for a lottery thinking it makes a difference. People throw dice harder thinking it makes a difference for a high number. The idea that people can influence their destiny, even by a fraction, encourages prisoners not to give up hope. Door open and door close in an elevator – many are not even connected. Fake temperature dials in offices – reduced energy bills. Overnight interest rates – the market reacts frenetically. Focus on what is important to you – and the rest, que sera, sera.

18. Incentive Super Response Tendency – Never pay our lawyer by the hour

To control rat infestation, French colonial rulers in Hanoi passed a law – for every dead rat, the catcher would receive a reward. Many rats were destroyed but many were bred for this purpose. Managers being paid for hitting targets – targets are lowered. People respond to incentives by doing what is in their best interest. Behavior changes quickly when incentives come to play. Good incentives comprise both intent and reward. They need not be monetary. Crusades – incentive – if you come back alive, you could keep the spoils of war. If you died you went to the afterlife as a martyr — a win- win.

19. Regression to Mean – The dubious effect of doctors, consultants, and psychotherapists

Back pains, record period of weather, bad- performing stock – they go back to the mean by themselves. Most successful stocks for the past three years will not be the most successful, or unlikely to be, for the coming three years. Look out for the regression to the mean error.

20. Outcome Bias – Never judge a decision by its outcome

We tend to evaluate decisions based on their results, rather than the decision process. The Pearl Harbor attack. From today’s perspective, there was plenty of evidence that an attack was imminent. Only in retrospect do the signals become clear. In 1941 there was a plethora of contradictory signals. To assess the quality of the decision, we must use the information available at the time.

Never judge a decision purely by its result especially when randomness and external factors play a role. A bad result does not automatically indicate a bad decision, or vice versa. Were your reasons rational and understandable? If so, stick to the method even if you did not strike it lucky the last time.

21. Paradox of Choice – Less is more

We are bombarded with choice. Abundance makes you giddy, but there is a limit. When it is exceeded, a surfeit of choices destroys the quality of life. A large selection may lead to inner paralysis. A broader decision leads to poorer decisions. How can you be sure you are making the right choice? You cannot.
Think carefully, write down the criteria, and stick to them rigidly. You can never make a perfect decision – learn to love a good choice. Only the best will do? Good enough as the new optimum?

22. Liking Bias – You like me, you really, really like me

There is nothing more effective in selling anything than getting the customer to believe, really believe, that you like him and care about him. The more we like someone, the more inclined we are to buy from or help that person. What does likable even mean? We see people as pleasant if they are outwardly attractive, if they are similar to us, and if they like us. Compliments work. Politicians are maestros of the liking bias.

23. Endowment Effect – Do not cling to things

We consider things more valuable the moment we own them. If we are selling something, we charge more for it than we ourselves are willing to spend to buy it. In real estate – the endowment effect is palpable – an emotional attachment. We are better at collecting than at casting out. Don’t cling to things – consider your property something that the universe has bestowed on you temporarily!

24. Coincidence – The inevitability of unlikely events

Improbable coincidence is exactly that – rare but possible events. “Never judge a decision purely by its result especially when randomness and external factors play a role. A bad result does not automatically indicate a bad decision or vice versa.” It is not surprising when they finally happen. What would be more surprising is if they never came to be.

25. Groupthink – The calamity of conformity

No one wants to be the naysayer that destroys team unity. Expressing reservations could mean exclusion from the team. Groupthink – where a group of smart people make reckless decisions because everyone aligns their opinion with the supposed consensus. If you find yourself in a tight unanimous group, you must speak your mind, even if your team does not like it – even if you risk expulsion from the warm nest. If you lead a group, appoint someone as a devil’s advocate. She may not be the most popular, but she might be the most important.