The Behavioural Investor
Cognitive Biases in Investing
Originally published in the Informanté newspaper on Thursday, July 30, 2015.
In a week where the world has seen major volatility in its major markets and commodities, with the Chinese stock market resuming its plunge despite herculean efforts by the People’s Bank of China to arrest the fall, including establishing a Plunge-Protection Team, as well as threats to arrest short-sellers, it is perhaps prudent to examine what motivates these markets.
For a great swathe in the history of economic thought, most theories were based on “homo economicus”, a view that people were rational and narrowly self-centred in their decision making processes. According to this view, people would be ‘utility-maximizing’ as consumers, and ‘profit-chasing’ as producers.
However, in 1994, noted neuroscientist António Damásio advanced his Somatic Marker Hypothesis in a book titled Descartes’ Error. He observed that patients with damage in the brain’s frontal lobe had an impaired ability to organize and plan, resulting in socially unacceptable behaviours. Individuals such as Phineas Gage, who bizarrely lived after a tamping iron was blasted through his head in 1848, had remarkable personality changes with damage to their frontal lobes.
Surprisingly, though, these individuals had a normal attention span, intellect, language comprehension and expression — the only change was in manifesting emotions. In fact, in patients that had lost the capability to feel emotion at all, also suffered from a sudden lack of any decision-making capability. Damásio had made a very unexpected discovery.
Emotions were always assumed to be irrational, and thus that a person without emotions would make better decisions. But Damásio’s findings showed that emotions are a crucial part of decision making — if you can’t feel, you can’t make up your mind. And so the myth of the rational actor was discarded, and new fields were born, ranging from cognitive science to behavioural finance. But perhaps the most important was the integration of our innate cognitive biases into economic theory.
These biases are mistakes we make in how we think and make choices, based on how we feel. Everyone believes they gather data and facts before coming to a conclusion, when in reality, we mostly already have our mind made up — and thus search only for data that confirms our conclusions. This is called confirmation bias. If no one is looking for information that disproves their conclusions, they’ll be caught flat-footed if reality disagrees with their conclusions.
Similarly, most people have an optimism bias. This is when our confidence in our judgement is greater than their accuracy. Generally, people tend to be correct only about 80% of the time when they are 99% sure of something. This effect can clearly be seen in the fact that 80% of drivers claim they are above average drivers! And yet 90% of people believe their future will be better and less painful than that of the average person.
And there are many more. Herding bias — the tendency to believe things because many people believe them to be true. Recency bias — where we expect recent events to continue indefinitely. Self-serving bias — where we believe good events that happen is a result of your own actions, whereas the bad ones are someone else’s fault.
And also, unfortunately, the bias blind-spot. Where, even though we know about all these biases and should factor them into our decision making, we lack the ability to recognize that we suffer from the same cognitive distortions as everyone else.
When we take a look at the Chinese market crash this week, it is all too obvious that everyone missed the signs. Herding, optimism bias, and even self-serving bias in the case of the Chinese government threatening to arrest short-sellers. “This time it’s different!” — the cry always heard at the top of a bull market just before the crash. In eight centuries those have always been the most dangerous words in investing. And it has never been different.
We believe Africa, and Namibia, to be different. Africa has the philosophy of Ubuntu, an essentially Humanist philosophy of kindness towards others. And the cry “Harambee,” Swahili for ‘Let’s pull together,’ surely these differences will prevent Namibia from experiencing the same kind of upheaval? Or are we, too, experiencing a bias blind-spot?
Originally published at theoryofinterest.blogspot.com on July 30, 2015.
