Perception Biases are caused by our emotional makeup and make us act in ways that prevent us from making decisions that allow economic utility maximization. In other words, they cause us to do stupid things that defy logic.
Some psychologists believe that we evolved these emotions and ways of thinking because somehow, they help us in an evolutionary way. Well…maybe this is true if you are being stalked by a man-eating lion in the wilderness but they certainly don’t help with investing.
I’m not a psychologist and maybe I have some of the details wrong here but the important thing is to be aware that as humans we are all perceptible to them. You…me…Aunt Mary…everyone. When you make a trading or investment decision you should ask yourself why you are doing it to make sure that the motivation isn’t purely emotional. This is a good reason to have and use a journal. By forcing yourself to write out the reasons why you are doing something it may make you realize that you are making a trade due to emotions and that usually isn’t good.
Here are some Perception Biases that are common to investing and trading. There is overlap between them but don’t be too worried about knowing the precise nuances of each. Just realize that they can make you lose a lot of money.
This is the tendency to see, interpret or remember things in a way that confirm a belief or hypothesis that we hold. This causes us to ignore or undervalue evidence that may be contrary to our opinion. For example, if we have an opinion on a particular position we tend to ignore or not give enough credence to information that may refute those opinions. You may be bullish on a particular stock and this may lead you to ignore or discredit an analyst who is making a compelling bearish argument on the stock, while giving too much credence to an analyst who is bullish on the stock but making a very weak argument in favor of it. This is an easy bias to succumb to. When I trade I try to avoid it by shutting off the TV and ignoring the media and the Wall Street ‘Gurus”. That way I can develop an unbiased opinion.
This bias is probably a manifestation of our innate tribal or herd instincts. This is the phenomenon that the more people believe in or do something then the more others will want to believe or do the same. Think of the phrase ‘spiraling out of control’. I suppose from an evolutionary perspective this bias makes plenty of sense because there is strength in numbers and animals that hunt in packs are more successful than animals that hunt alone.
The way you can really see this is with the illogic of sports and sports fans. They may not even know someone but because another random person is wearing the shirt of their favorite team somehow, they have a special bond. This bias also explains fashion trends. Why do fashions become popular and why are they so important? We laugh and think that people dressed like fools in the past if we see pictures from Shakespearian or Victorian days. Well…think about today. What about a tie? In the future people are going to laugh and talk about how stupid we are for wearing and thinking that ties look good. You think your tie or your dress or your hat or whatever looks good because you have the bandwagon bias.
Obviously, this is a bias than can negatively affect trading because although you want to be on the bandwagon and a member of the pack while things are trending up or down, you don’t want to be on the bandwagon when trends are about to turn.
This is when we put too much emphasis on recent events and think that they will somehow influence future events. It is the mistaken belief that if something happens more frequently than expected then it will happen less frequently in the future. The classic example is flipping a coin. Suppose I flip a coin and I get ‘heads’ ten times in a row. What are the odds of the next flip being heads? Most people would feel that a ‘tails’ is due. They would then assume that in the next flip I would get ‘tails’ despite the fact that it is still exactly a 50% chance.
Positive Expectation Bias
Casinos and the gambling industry wouldn’t exist if people weren’t susceptible to this bias. This is when we feel our luck is due to change despite the fact that statistics and probabilities don’t bear this out. Think of the person who plays slot machines. They keep pouring in money because they believe their luck is due to change. Yet the slot machine is a computer. It can’t lose.
In trading and investing this could lead us to hold on to our losers and average down. They say that the definition of insanity is doing the same thing over and over and expecting a different result. Maybe its true insanity and maybe it isn’t. But it seems pretty obvious to me that this is caused by the fact that people have this bias. They expect things to be different despite the contrary and opposing evidence.
This bias comes from thinking too short-term. We use the most notable or most obvious traits to make a judgment about a situation while forgetting things that have happened in the past. If we haven’t encountered something recently we tend to ignore or down play its probabilities. This leads to the ability to think “this time it’s different”. That’s why in Bubbles or Crashes people forget that the market will eventually go down or rise. They get too focused on the short-term and forget that history repeats itself. If you are aware of this bias in others you can make a fortune in the next Bubble. And yes…there will be more bubbles as long as there are markets and there are humans investing in the markets because humans possess this bias.
This is the bias of thinking that other people think in the same way that we do. You just kind of assume that everyone else views life in the same way that you do. That is why sleazy people don’t mind taking advantage of or cheating others. It is because they believe that the other person is equally capable of doing the same thing to them. Similarly, people who are good are likely to be taken advantage of because they assume that other people are good like they are. I’m not so sure how this directly applies to investing, but it’s a great life lesson so I included it.
This is when you need to make a guess but only have limited information. There is a tendency to rely too heavily on the first piece of information that is received when individuals use an initial piece of information to make subsequent judgements. The first number ‘anchors’ your opinion. A classic example is the way menus are laid-out in highly priced restaurants. The first entrée is typically very high priced and after you see this it makes the other items seem like a bargain. Wise restaurant owners make the second highest price item have the best profit margins because they know that their customers are most likely to order it.
Another example is how in a store when someone sees an item that is on sale they focus on the amount of money that is (allegedly) saved as opposed to the initial value which could be highly overinflated. An item may seem like a bargain at 30% off. But what if the day before the price went from $50 to $100? Paying $70 is better than paying $100…but it is still more than $50.
In investing or trading this could lead us to think a stock is worth buying just because it is down, or it is at a nice round number. For example, think of how appealing the idea of buying a stock at $5 a share if just a month prior it was at $10. The reality is that it could go to zero.