One of the aspects of investing that I have long enjoyed is looking at the many ways are wetware works against us. Despite what nearly half of America believes, we have evolved in a certain way, and that has significant repercussions for our analytical processes.
There are many ways our brain wiring fools us. I discussed a few in the Apprenticed Investor series — Know Thyself and Curb Your Enthusiasm — that are worth revisiting. And one of the favored books around here is Thomas Gilovich: How We Know What Isn’t So.
Many of the common foibles investors get themselves into can be tracked to our propensity for cognitive bias. What our minds commonly do to distort our own view of reality has an impact on our invement results.
So you can imagine my surprise and delight when I stumbled upon this Wikipedia list. Here are the 26 most studied and widely accepted cognitive biases:
- Bandwagon effect – the tendency to do (or believe) things because many other people do (or believe) the same. Related to groupthink, herd behaviour, and manias. Carl Jung pioneered the idea of the collective unconscious which is considered by Jungian psychologists to be responsible for this cognitive bias.
- Bias blind spot – the tendency not to compensate for one’s own cognitive biases.
- Choice-supportive bias – the tendency to remember one’s choices as better than they actually were.
- Confirmation bias – the tendency to search for or interpret information in a way that confirms one’s preconceptions.
- Congruence bias – the tendency to test hypotheses exclusively through direct testing.
- Contrast effect – the enhancement or diminishment of a weight or other measurement when compared with recently observed contrasting object.
- Déformation professionnelle – the tendency to look at things according to the conventions of one’s own profession, forgetting any broader point of view.
- Disconfirmation bias – the tendency for people to extend critical scrutiny to information which contradicts their prior beliefs and uncritically accept information that is congruent with their prior beliefs.
- Endowment effect – the tendency for people to value something more as soon as they own it.
- Focusing effect – prediction bias occurring when people place too much importance on one aspect of an event; causes error in accurately predicting the utility of a future outcome.
- Hyperbolic discounting – the tendency for people to have a stronger preference for more immediate payoffs relative to later payoffs, the closer to the present both payoffs are.
- Illusion of control – the tendency for human beings to believe they can control or at least influence outcomes which they clearly cannot.
- Impact bias – the tendency for people to overestimate the length or the intensity of the impact of future feeling states.
- Information bias – the tendency to seek information even when it cannot affect action.
- Loss aversion – the tendency for people to strongly prefer avoiding losses over acquiring gains (see also sunk cost effects)
- Neglect of probability – the tendency to completely disregard probability when making a decision under uncertainty.
- Mere exposure effect – the tendency for people to express undue liking for things merely because they are familiar with them.
- Omission bias – The tendency to judge harmful actions as worse, or less moral, than equally harmful omissions (inactions).
- Outcome bias – the tendency to judge a decision by its eventual outcome instead of based on the quality of the decision at the time it was made.
- Planning fallacy – the tendency to underestimate task-completion times.
- Post-purchase rationalization – the tendency to persuade oneself through rational argument that a purchase was a good value.
- Pseudocertainty effect – the tendency to make risk-averse choices if the expected outcome is positive, but make risk-seeking choices to avoid negative outcomes.
- Selective perception – the tendency for expectations to affect perception.
- Status quo bias – the tendency for people to like things to stay relatively the same.
- Von Restorff effect – the tendency for an item that “stands out like a sore thumb” to be more likely to be remembered than other items.
- Zero-risk bias – preference for reducing a small risk to zero over a greater reduction in a larger risk.
Complete list of cognitive biases – Wikipedia
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via Healthbolt
“Outcome bias – the tendency to judge a decision by its eventual outcome instead of based on the quality of the decision at the time it was made.”
One of my favorite graduate finance professors had a saying, “Right decision, wrong outcome.”
I have had many right decisions with he wrong outcome but my decision process hasn’t changed.
Another favorite saying was by an accounting professor who said of accounting, ” Where are, where do you need to be, how do you get there.” Again emphasis on the process, “how” do you get there.
Good list BR.
I know you scoff at some of the more traditional trains of thought, but there is great value in that type of introspection, though it is structured and dogmatic. I’ve been checking out this blog for about a year now, and I see a lot of “progressiveness”. Though this disappoints me, a different way of thinking about economics is welcome to me, a newbie amateur economist, and I enjoy the posts on jazz (though I still dislike most jazz; even the post on jazz for people who dislike jazz had little affect on me).
BTW, delicious irony that your wikipedia link on bias first lists hindsight bias, then lists confirmation bias third, both of which you suffer from greatly in your political views. I also amusingly noted top of your list (it was alphabetical) was bandwagon effect; I find that your admiration for Soros (or maybe Soros’ success) has obviously bled over into you jumping on his bandwagon.
Like I said, I love your blog, and find great comfort that you have the freedom to run it as you see fit.
Here’s to us: may we eventually know everything, and not be embarassed by our previous assertions (or foolishness, as the case may be),
Rob
“…delicious irony that your wikipedia link on bias first lists hindsight bias, then lists confirmation bias third, both of which you suffer from greatly …”
Doubly delicious considering the biases inherent in your critique; thanks for the chuckle.
Thanks for the hint. I was vaguely aware that feelings were important in investment decisions, but didn’t know there were people who had considered C.G. Jung’s collective unconsciousness in that regard, let alone built up a list of different aspects of what presumably is going on. Working backwards from some of those cognitive biases might well be helpful in understanding Jung’s basic idea.
One of the ways is homophones… our and are, for instance.
:-)
Rob,
And then there’s that whole superiority bias… my ideas are better’n yours…
Oh, and where is your blog again, Rob? You’re more than free to spout your own views there, you know.
Great post, Barry…
Of course, the concept of “Know Thyself” goes beyond understanding human behavior — it is understanding one’s own personal strengths and weaknesses and, more importantly, being aware of one’s own ignorance, which, in my view, is a fundamental necessity for “successful” investing and life in general.
There are many brilliant minds displaying their intelligence on financial blogs (and making comments to your posts everyday). I find it amusing that many (but not all) of those individuals’ egos will not allow them to see their own ignorance; however, they are quick to cite the perceived ignorance of others…
Keep up the good logic…
Kent (aka The Financial Philosopher)
Cool list. After I read HWNWIS I asked Gilovich what I could read to pursue the issue more deeply and he recommended Human Inference by Nisbett and Ross. I loved it.
Also one of my favorite topics! I heard it here first–bought Gilovich’s book on Barry’s recommendation and really enjoyed it. I particularly like what Gilovich calls
the regression effect, also known as regression bias. So much so that I
can’t resist repeating one of his examples here (somewhat modified).
If parents believe that their children learn quickly from reward and punishment, then
regression bias will tend to lead them over time towards mainly punitive behavior towards their children. What is the argument for this?
Let us agree that random fluctuations of better and worse is a reasonable model of children’s behavior in the short term, and that in particular, notable instances of bad behavior are likely to be followed by instances of more average behavior (regression to the mean). Similarly with notable instances of good behavior.
Now consider a family in with parents as described above. Whenever the children behave notably well, the parents reward them. The good behavior is then usually followed by more average (worse) behavior, so the parents take away the lesson that the reward has either not worked or somehow even discouraged good behavior. Whenever the children behave notably badly, the parents punish them. The bad behavior is then usually followed by more average (better) behavior, so the parents take away the lesson the the punishment has had its desired effect. So the parents’ incorrect mode of interpretation of random mean regression as a reflection of their rewards and punishments acts as feedback on them, discouraging them when they reward and encouraging them when they punish.
Ironically, as Gilovich states, it is well known to child psychologists that the best thing for children is attentive parents who are generally positive–over time, this will lead the kids towards good behavior, although there will always be random fluctuations.
Like each of you primates, I also suffer from Cognitive Biases.
However, I’d like to think I am somewhat more aware of that particular foibles than the average pants wearing monkey.
Not that means a whole lot, but its a start . . .
Maybe if all those other people didn’t suffer from all those biases, my stocks wouldn’t go the wrong way. It’s all their fault. I wish they’d get some knowledge.
My apologies for making some of you angry. Barry I enjoy your site much, and did not mean to imply I CAN’T see the world from your point of view politically; just that I don’t. I visit this blog in a way wholly unlike liberals who listen to Rush (the partisan and mostly wrong, but somewhat entertaining Republican–I won’t say conservative–commentator).
Barry, thank for keeping my comment on the blog. I hope you understand what I’m trying to say. Keep up the great work. BTW, largely thanks to you, I’ve found I love piano jazz, only.
p.s. If you’ve got any insight on Black-Scholes, I’d love to read it.