October 5, 2021
Mental Shortcuts and the Lurking Threat of Cognitive Bias Pt. II

In my previous post, I shed light on a few sneaky tricks our mind plays on us in the face of complex decisions. If you haven’t read my introduction to Mental Shortcuts and the Lurking Threat of Cognitive Bias 1, I encourage you to begin your journey with the above before jumping straight into the Valley of Despair of cognition errors (you don’t want to jump straight into the Valley of Despair)!

Pynk Community - Lurking threat of Cognitive Bias blog_Confidence vs. Wisdom

When coming to grips with a new discipline, each person is “doomed” to follow the same learning path. This is what the Dunning-Krueger Effect teaches us. Padawans of financial enlightenment are not exempt. One starts off on the peak of Mt. Stupid, where the level of knowledge is minimal, and the illusion of expertise flourishes. This can set anybody up for serious trouble, especially if money is involved. Those who decide to test the waters of financial enlightenment realize how little they know, hence finding themselves in the Valley of Despair. They uncover the complexity of building a healthy financial life and the fallacies of get-rich-quick schemes. Many are overwhelmed and give up at this stage. Nonetheless, those committed to studying the arts of financial enlightenment choose to adventure on the Slope of Enlightenment in pursuit of answers to the tribal concepts of compounding returns, the time value of money, and inflation. These are the kind of concepts that finance professionals throw into conversation with confidence. If you are reading this, it is clear that you haven’t given up. The Pynk community salutes you! With knowledge and experience, novices of financial enlightenment come up with the wildest of questions that pop to mind, bearing in mind the quest of becoming masters in the arts of financial enlightenment and financial health. If this resonates with you, then you are where you’re supposed to be!

Irrespective of the learning stage you find yourself at, learning the basics of mental shortcuts and cognitive biases is key to making sound(er) financial decisions. Find below another batch of handpicked cognitive biases that your mind has in store for you.

Action Bias

The first bias we are going to address in this thread is the action bias. The action bias can be defined as a tendency to favour action over inaction, even without a solid rationale to support the decision to act. This cognitive bias is prominent in the world of investing, especially when people make rash decisions about their investments in the face of market volatility.

Let’s assume that you have invested 10% of your savings into an investment portfolio that matches your risk profile, and decided to stay invested for at least 10 years to reap the benefits of compounding returns. What do you do in the face of an economic downturn? Is withdrawing your savings a rational idea? Assuming that the fundamental research you have conducted gives you strong convictions about the composition of the investment portfolio or about the asset managers that actively manage it, doing nothing might be the one option that keeps your assets safe. Given the cyclical nature of the economy, time is expected to ride out the market volatility such that your savings remain safe under the eyes of sophisticated investors.

Hot-Hand Fallacy

The hot-hand fallacy is another way of saying “past performance is not indicative of future performance”, especially when it comes to relying on unsophisticated investors to deliver consistent positive returns. With the pandemic-fuelled boom in brokerage accounts also came an increase in the number of trading and ‘investment’ gurus who seek to acquire the attention of wishful traders / ’investors’ wanting to ‘make a killing’. In layman’s terms, the hot-hand fallacy is described as a tendency to believe that someone successful in an activity is more likely to be successful in future attempts. Usually, this is not the case.

(As a side note, I believe this also applies to companies that gain popularity based on their recent performance, which usually leads to a further price increase - see Tesla). It is not uncommon for market participants to assign overstretched valuations to recently successful companies, valuations that go beyond sustainable earnings expectations. This could be described in one word as “herding”. Assuming that people influenced by the hot-hand fallacy become a sizable share of market participants, one could wonder whether this cognitive bias actually has significant explanatory power for the recent dislocation of the financial market.)

Making investment decisions requires us to be inquisitive and rigorous. Do the sources I use to learn about investment ideas and trends employ an informative tone or a persuasive one? Do the sources I follow or the platforms I use make me feel safe and better informed, or anxious? Is my decision to invest based on fundamentals (Pouneh wrote a great piece about this!) or the seemingly good run the company has recently had?

Play devil’s advocate. In other words, be curious and test arguments that go against your ideas and belief system. This is an effective approach to navigate complex decisions. Think about it as a trust distribution mechanism. While sources that nurture your knowledge and well-researched investment ideas can be trusted as actionable information, controversial sources and unjustified investment ideas should fall by the wayside.

Note: Persuasion does not belong in a learning environment!

Availability Heuristic

The availability heuristic describes our tendency to use information that can be easily recalled to make decisions about the future. Let’s assume you have recently made a decision to invest in TSMC. You have strong convictions about it because of the long-term fundamentals you have identified in the semiconductor industry following an in-depth analysis. One month later, you learn that TSMC fails to meet analyst expectations, resulting in a drop in its share value. Being stunned by this unexpected event, the mental shortcut described above may kick in, leading you to sell your position based on the newly acquired information, irrespective of the fundamental analysis you have conducted.

Oftentimes, the information one uses under the influence of the availability heuristic is frequently insufficient for figuring out the best course of action. This tends to lead to rash decision-making. You need to ask yourself. Did the news change the long-term fundamentals of the company? Are there factors that support a further drop in the share price? Based on the envisioned investment horizon, is the current drop meaningful?

Note that this doesn’t mean there can’t be changes in a company’s long-term prospects. As Pouneh highlighted in A Key To Better Returns…… Review Your Portfolio With Fresh Eyes, the dynamic nature of financial markets compels both sophisticated and unsophisticated investors to periodically revisit the assumptions they make about the risk/reward scenarios associated with any given investment. Hence, taking a step back to re-evaluate where you’re standing is better than making complex decisions based on limited information.

Now It’s Your Turn!

Above all, the goal of the Pynk community is to create an environment where we can reinforce one another on the path towards financial enlightenment, and one way to do this is by learning from each other’s mistakes. Share your experience with us by answering the questions below!

  • Which of the above cognitive biases have you encountered?
  • Tell us about a time you fell prey to a cognitive bias?
  • What did you learn from it and how could you have done it differently?

This information does not constitute any form of advice or recommendation by Pynk One Ltd. and is not intended to be relied upon by users in making (or refraining from making) any investment decisions.

When investing, your capital is at risk and you may recover less than the initial investment.

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Written by
Razvan-Maria Paun
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