BEWARE THE ‘SPECIAL CASE’ – Confirmation Bias

The confirmation bias is the mother of all misconceptions. It is the tendency to interpret new information so that it becomes compatible with our existing theories, beliefs and convictions.

We have some initial thoughts, opinion on anything and we try to collect information, evidence which supports our initial thoughts. And kick out evidence which does not support our initial thoughts.

We inevitably land in communities of like-minded people, further reinforcing our convictions – and the confirmation bias. We generally like people who have similar interest as of us. So, this association will again influence our decision making. We should have people in our life who can show us the other side of the coin rather keep supporting our views. Our mind does not accept opposite views so that we have to make it habituate our mind to accept the opposite idea. 

Business – When any management makes any kind of capital allocation decision then they will start collecting information which is supporting their decision. But we should check that management get succeed who have a focus on both optimistic as well as a pessimistic result of their decision.

We have mainly seen such behaviour among the management of cyclical industries. When the business cycle starts improving, then management focuses on increasing higher capacity, disturbing balance sheet, etc. rather improve efficiency and strengthening balance sheet to be ready for an upcoming burst in the cycle. Good management focuses on increasing capacity when everyone avoids so that they can take benefits when the cycle turns to be profitable.

Investment – When we have invested in a particular company, we try to find out evidence which supports our investment, which tells us that we will gain from this investment. When we are fully invested with all our money, we work on identifying evidence which tells us that market will do well and we will earn good returns. Reversely, when we have a huge fund to get invested, we work on collecting evidence that tells us market will go down and we will get good investment opportunities. Rather falling in confirmation bias, we should try to collect positive as well as negative evidence with a neutral mind decide to continue with original thoughts or to modify or change it.

Many a time, I have seen that people get emotionally attached to their investment so that they do not want to hear anything against their investment. We have to understand that our decision does not prove to be correct every time.

We should write down our initial belief and work on collecting disconfirming evidence to our initial belief. When we have confirmed as well as disconfirming evidence then we can make wise & rational decision without getting biased. When we have invested in a particular company then we should prepare a sell report on the same company. And if we have not invested then should work on collecting evidence which tells us why we should invest at the current point of time.

This entire series will be review with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.

DON’T ACCEPT FREE DRINKS – Reciprocity

Many NGOs, philanthropic institutions give us a gift and welcome us. After that when they feel that we have fallen under the softcore for them due to gift, they ask for the donation. Reciprocity is a very useful survival strategy, a form of risk management.

It is at the core of cooperation between people who are not related to each other and a necessary ingredient for economic growth and wealth creation. Reciprocity rule said that we try to repay what we get from someone. At last, we all are social animals. And when we give something to someone, we expect something in return. This is how our social life has been designed. This bias is so strong that by this, we can influence thinking and decision making of other people.

Business – This method is best used by marketing fellow who comes to us with some exciting advice free of cost and in return, we will buy what they are selling. When sales personnel put lots of efforts on us then we try to buy something from them. When any company keeps taking care of their customers such as sending wishes on their birthday, anniversary, sending gifts, etc. then those happy customers will buy services from that company on a repeated basis.

Investment – when we like the products or services of a particular company, we try to put our money into it. It is a good decision at some extend but without digging in detail putting money is an unwise decision.

Many a time, our advisors also get some benefits from the company or they like the products or services of the company so that they issue buy recommendations. Opposite of it that sometimes, any unsatisfied with the product or service of any company to any of our advisors then they might start advising to stay away from that company to put money.

We should not blindly follow anyone rather doing their homework. For overcoming this bias, we need to give us a time, we need to dig deeper on each aspect of the company. We need to write down a thesis which contains the opposite side of our decision. It’s difficult to kill your idea but its necessary.

One of the power generation and transmission business – very lower return to no return in the last 14 years

One of the telecom company of India- also low return in the last 14 years

Dialogue from Mr Salman Khan best suitable to this bias – Do me a favour, that doesn’t do me any favours. (Idea taken from SafalNiveshak)

Disclosure – Companies mentioned in the article are just for an example & educational purpose. It is not a buy/sell/ hold recommendation.

This entire series will be review with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.

WHY YOU SHOULD FORGET THE PAST – Sunk Cost Fallacy

For Humans, mental accounts are a form of narrow framing; they keep things under control and manageable by a finite mind.

The decision to invest additional resources in a losing account, though better investments are available. This is known as the sunk-cost fallacy, a costly mistake that is observed in decisions large and small.

Many financial institutions refinance bad loans with the hope of recovering them. If the company starts doing well through an additional loan then should give an additional loan rather than book it as an NPA. This will result in a larger bad loan on the book of institutions.

We have seen that loss-making business or division keeps getting funds from the bank or financial institutions. Also, many non-performing banks keep getting recapitalization from the government. This is an example of a fall of government into the sunk cost fallacy. We have seen in “Mahabharata” that King Yudhishthira keeps on gambling with the hope of winning everything back. He considered his brothers and wife as an available resource and played for winning back his lost fortune.

Investment – When we have invested in a few stocks and those turn out to be our mistakes but we resist booked losses from it. We think that if we book losses then it will occur but we do not think that loss already occurs, just we have not accepted it. A common practice by the majority of investors follow is to book winners and hold on with losers or average losers.

The sunk cost fallacy is most dangerous when we have invested a lot of time, money, energy, or love in something. We carry out with the burden of losses and invest more in it. As we invest more, we fall further into the trap of sunk cost fallacy and cannot take the exit with losses. This is irrational. I have seen many fund managers/research analysts who cannot reject ideas after they have made good efforts, though they found something wrong about their investment idea.

Overcoming a Sunk cost fallacy, we have to understand that the acquisition price has no role to play while making an investment decision. What counts is the stock’s future performance (and the future performance of alternative investments). So that if we feel that stock is more valuable and have the potential to perform well in the future based on its fundamental (not on basis of gut feelings) from current price then only we have to hold it or invest in it. We have to delete buy price column or have to ignore it. If we have found that business has some problem and will not grow it or will not sustain then we must have to take exit because holding that will defiantly going to give us a permanent loss of capital. 

We can see in the mentioned link that the public has increased their holdings in stocks which have eroded wealth.

QUALITY INVESTING CAN BE A CONTRARIAN INVESTING….

This entire series will be review with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.

IF 50 MILLION PEOPLE SAY SOMETHING FOOLISH, IT IS STILL FOOLISH – Social Proof

We generally accept something as right when others are also performing it and we also start following the same. When one starts clapping at Drama show, all other starts clapping and join that fellow.

Social proof is the evil behind bubbles and stock market panic. It exists in fashion, management techniques, hobbies, religion and diets. It can paralyze whole cultures, such as when sects commit collective suicide.

It has been seen in students, they select particular stream as their career because their friends or others in their family has select it. They do not focus on what they like, whether that stream is suitable to them or not.

We have seen that when a few streams are in fashion; the majority of students chase that same stream rather focus on their skill or interest. We are a human animal so that human emotions affect our decisions.

Every time social proof does not create trouble. When we decide to go out for dinner and found 2 restaurant from which one has a crowd but other is vacant. Here, we should generally prefer a restaurant with a crowd. Herding becomes particularly useful in ambiguous situations because it simplifies the decision-making process. We should follow the crowd when the decision does not have a huge impact on our financial or in life.

Investment – When few start talking about buying a few equity investments than others also start following it and by seeing them succeed more will join their party. That will result in a bubble or burst.

We follow others without thinking about anything. When we see a few others are doing something then our mind stops giving us logical reasoning. I have met a few people before Covid-19 market panic. They were telling me that I should make the large investment as many mutual funds and PMSs have generated good returns in past. If you will not invest then you will miss out an opportunity. We should not follow what others doing rather should focus on their process. Equity investment has created wealth for people and beats inflation so everyone starts herd towards it without thinking about anything and any level. All the assets class has its merits-demerits so that we need to choose an assets class according to our temperaments rather chasing what others are doing.

Majority of the fund managers also follow social proof. If we see the various scheme of the same categories then the majority of the fund has a similar kind of portfolio. They focus on matching their benchmark return. We can see below portfolio of four different schemes of different AMCs, all those have many common stocks in their top-5 holdings.

For overcoming social proof bias, we need to create our circle of competence and investment process. We need to stick with it and let others do whatever they want to do. For example, if pure cyclical businesses do not fall under our circle of competence then we should avoid it though anyone has bought it. Also, the famous quote of Mr Buffett tells us a lot about overcoming social proof bias.

This entire series will be review with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.

WHY YOU SEE SHAPES IN THE CLOUDS – Clustering Illusion

Many a time, people see the face of lord or shape of the lord, shape of a heart and so on in clouds. We hear many strange voices sometimes and feel that it wants to talk to us. The human brain seeks patterns and rules. It takes one step further: if it finds no familiar patterns, it simply invents some.

In the above images, we can see different faces in clouds. But actually, there is not any real face, our imagination creates faces in it.

Investment – In the market, we are getting overloaded with lots of data and many of us try to make patterns among those data. They use such pattern for trading into stocks. But that not work forever because we have created patterns where it has no existence.

When it comes to pattern recognition, we are oversensitive. We need to regain our scepticism. If you think you have discovered a pattern, first consider it a pure chance. If it seems too good to be true, find data which is tested mathematically and statistically. Never believe in any pattern if it is not supported with enough data over a long time.

Many investors believe that the company which choose buyback as a capital allocation plan then consider that company as a good capital allocator. But do we check rather a buyback is done below its intrinsic value or above its intrinsic value? What is the intension of the company behind buyback? Does the company want to hide previously diluted equity capital through buyback? So, we need to be sceptical before considering something as it similar as we saw it.

SIMPLE IS BETTER – ISSUE -13 – BUYBACK

This entire series will be review with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.

DOES HARVARD MAKE YOU SMARTER? Swimmer’s Body Illusion

For becoming good swimmers, we require a good body to develop. This is not a fact but it’s a result of good swimming. Female models advertise cosmetics and thus, many female consumers believe that these products make them beautiful. But it is not the cosmetics that make these women model-like.

Whenever we confuse selection factors with results, we fall under swimmers body illusions. When it’s talking about top graduate schools then Harvard, Oxford, MIT, IIM comes on top and it is considered that pass out from those colleges will give huge success in professional life but is it true always? It may be possible that they give admission to already bright students so they do well and get a good professional life.

Investment – Mr Buffett has made wealth through moat investment so we all chase his style without knowing that it will suit us or not, without knowing that Mr Buffett also owns world’s largest insurance company which generates good float for him to invest. 

So, when we stuck under such situations, we should write down what confusing us then invert that problem. In investment, people believe that high dividend-paying companies are good. But we should understand that the company is good because it can able to generate cash which is excess after investing in all business requirements so that the company can able to pay a higher dividend. Whenever any outcome or information we received, we need to always ask a question on how that outcome has resulted. We need to understand why some companies are successful and why some not rather using any thumb rules.

This entire series will be review with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.

WHY YOU SHOULD VISIT CEMETERIES – Survivorship Bias

In life, we focus more on winning, surviving rather than failure. This illusion kills our ability to calculate the probability of surviving, success. We cannot see that probability of success can be very small. We always taught about success and not taught about failure. This is known as a survivorship bias.

Many authors write a book but a few will achieve success. Thomas Edison failed many times before inventing of the bulb but today, we only remember with their success, survivor.

“I’ve missed more than 9000 shots in my career. I’ve lost almost 300 games. 26 times I’ve been trusted to take the game-winning shot … and missed. I’ve failed over and over and over again in my life. That is why I succeed.” ~ Michael Jordan

Investment – Similarly, very few have achieved success in the investment world but we overestimate the probability of success and ignore to look that many have spoiled their life. We focus on successful companies which have created a lot of wealth. When we visit any seminar or marketing people or media, they only talk about the successful companies which have created wealth but never talk about companies which have eroded wealth. Wealth creators are very few compared to wealth eroded. But we ignore the probability of losing and never try to learn from others mistakes. We all come to the stock market for becoming a next Mr Buffett but does not focus on developing ability and insights as similar to Mr Buffett & Mr Munger.

There are ~7000+ companies got listed on Indian bourse from that ~4294 companies are down almost 80%+ (many companies got unlisted or close) whereas we know that few companies which have generated wealth over a period. So ~60% of wealth destroyers are there compared to hardly ~3% wealth creators (maximum- if we see actual wealth creators for long term then that is ~1% only).

We can see that there are huge wealth destroyers companies available compared to few wealth creators. So that while investing don’t try to catch every opportunity available but prepare investment philosophy suitable to us, swing bat only when the suitable opportunity arrives. We need to prepare investment philosophy, process, circle of competence and investment style so that we can swing bat when things fall under our zone.

This entire series will be review with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.

05 – Illusion

Illusions of Remembering

The illusion is not only of visual but it’s also of memory.

If we have seen any words or something for even a millisecond then also when we see it again we feel it familiar. Something which is in contrast to others that also give us a feeling of familiars. This creates a memory illusion.

Illusions of Truth

When things seem familiar, we generally tend to accept it as truth. But when things seem unfamiliar or extreme then we tend to reject it.

The impression of familiarity is produced by System 1, and System 2 relies on that impression for a true/false judgment.

When we wanted something to accept by people as truth then we keep on repeating the same. Because familiar things are easy to accept as truth.

When we listen frequently that equity investment or real estate investment can help us to create wealth then we become familiar to it and we start believing it as a truth. When we see people surrounding us making money through trading then we also believe it as a truth. We also start doing it without thinking about it as a truth or not. It keeps getting repeatedly visible in front of us and we believe it as a truth.

How to Write a Persuasive Message

When we write something truth but it is not necessary that people also believe it as a truth. For that, we need to use a true illusion. We need to draft our writing in a good manner, with proper colour combination and do not make it very complex, make it memorable.

Strain and Effort

The performance was better with the bad font. Cognitive strain, whatever its source, mobilizes System 2, which is more likely to reject the intuitive answer suggested by System 1.

The Pleasure of Cognitive Ease

Companies with pronounceable names correctly better than others for the first week after the stock is issued, though the effect disappears over time. Stocks with pronounceable trading symbols (like KAR or LUNMOO) outperform those with tongue-twisting tickers like PXG or RDO —and they appear to retain a small advantage over some time.

Ease, Mood, and Intuition

Our mood has an impact on system 1 and intuition. When we are uncomfortable, suspicious and unhappy, we lose touch with our intuition. And our system 2 take control. Reversely when we are happy, comfortable then system 1 take control.

So that we need to understand our mood while making any investment decision. If we are in good mood then our system 1 will take charge and we might not be getting involved in the proper analysis of our own decisions.

Norms, Surprises, and Causes

Assessing Normality

The main function of System 1 is to maintain and update a model of your personal world, which represents what is normal in it. The model is constructed by associations that link ideas of circumstances, events, actions, and outcomes that co-occur with some regularity, either at the same time or within a relatively short interval. As these links are formed and strengthened, the pattern of associated ideas comes to represent the structure of events in your life, and it determines your interpretation of the present as well as your expectations of the future.

When something happens or surprise our first time, when similar happens again, we will get lessor surprise or treat it as a normal. Our system 2 suggest that this is not a normal but system 1 made it. Whenever we met any surprises for the first time, our mind expects similar to happens again while a similar situation arises. That previous incident becomes normal for us and if that similar incident will not occur then we get more surprised.

It has been previously happening that market falls and get recover from that fall within 1-2 years. So that when the market falls everyone thinks that it will recover easily and we should invest. But there is a possibility that it may take a longer time to recover then what it used to be in past. So that we should not believe blindly that what has happened in past can happen in future also. It can have a higher probability to happen similar but also should not ignore the probability to not happen the same again or in the same time period.

Seeing Causes and Intentions

We generally use casual intuition frequently. For example, if someone says that he lost his wallet, then first thought comes of pickpocket rather than put somewhere, forget at restaurants, etc.

A Machine for Jumping to Conclusions

Jumping to conclusions is efficient if the conclusions are likely to be correct and the costs of an occasional mistake acceptable, and if the jump saves much time and effort. Jumping to conclusions is risky when the situation is unfamiliar, the stakes are high, and there is no time to collect more information. We should not jump to the conclusion where we know that involvement of system 2 is essential. It has a higher probability to meet error if we jump to the conclusion without taking the help of system 2.

04 – Intelligence, Control, Rationality

Intelligence, Control, Rationality

One research is done on the four-year-old children. They have given one marshmallow and told them to eat it anytime but if they wait for the 15 minutes then they will get one more.

Video of marshmallow

Ten or fifteen years later, a large gap had opened between those who had resisted temptation and those who had not. Those who show higher self-control, those also have scored higher in intelligence test during the adult time.

Stanovich has talked about two minds of system 2. One of these minds (he calls it algorithmic) deals with slow thinking and demanding computation. These measures calculation skills and intelligence. Second is rational thinking.

The Associative Machine

When we listen or see or read something disgusting than our mind immediately connects it and start preparing pictures of it. The mind will start associating a word with many different elements and we temporarily fall under those emotions. If we have heard the highway accident, then our mind starts preparing some pictures, incidents of it and we stay away for some period from it. This concept is known as associative activation.

These responses occurred quickly, automatically and effortlessly. System 1 shows those words as a reality and our body starts reacting on it. These words activate some thoughts, that activates other thoughts. When we have read or listened to the news of recession in the automobile industry in the year 2019. Our mind starts creating an image of it so that we stay away from investing in the automobile industry. But if we use system 2 and make a rational decision then scenario can be entirely different for us.

The Marvels of Priming

When we see some puzzling things then we connect it with recent activities which we have performed or something is in our mind currently. If you have recently seen or heard the word EAT, you are temporarily more likely to complete the word fragment SO_P as SOUP than as SOAP. The opposite would happen, of course, if you had just seen WASH. We call this a priming effect and say that the idea of EAT primes the idea of SOUP, and that WASH primes SOAP.

If you were primed to think of old age, you would tend to act old, and acting old would reinforce the thought of old age. So that we behave the way we get primed.

Primes That Guide Us

Our surroundings are also responsible for build primes in us. For example, if we surrounded by money-minded people, our behaviour starts becoming money minded. What we see, listens are also affects our behaviour.

System 1 provides the impressions that often turn into your beliefs, and is the source of the impulses that often become your choices and your actions.

System 1 creates a story and system 2 believes it. So that later on it becomes our belief.

When we surrounded by short term oriented, traders mentality, lazy, etc. then system 1 starts creating a story and our behaviour starts forming like our surroundings. Thus, if you want to become an investor then you have to keep distance with people who have a trader mindset otherwise trading will get priming to our mind and we will get diverted towards trading activities.

Cognitive Ease

Whether we are conscious or not, there are lots of calculations and thinking of running in our brain. These all done through system 1. These calculations through system 1 keep on assessing various situations, survival, threats etc.

These works in a range of easy and strain.

Easy is a sign that things are going well—no threats, no major news, no need to redirect attention or mobilize effort. Strained indicates that a problem exists, which will require the increased mobilization of System 2.

Cognitive ease happens when we are in a good mood, sentence which we read is in clear fonts, proper colour, etc. and reversely cognitive strain happens when we are in a bad mood, sentence which we read are poorly written, not clear fonts, poor colour combination, etc.

When we are into cognitive ease state, we are in good mood, we believe what we hear, trust intuition, be creative etc. But when we are into cognitive strain state then we are effortful, suspicious, feel less comfortable, make fewer errors, etc. When we have invested in a particular company and the price of it keeps raising, we start staying in cognitive ease so that we do not focus on the fundamental side. Whereas when prices not raising then only people get cognitive strain and focus on fundamental parts.

This entire series will be review with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.

03 – System 2 efforts

Attention and Effort

System 2 is effortful and one of its main characteristics is laziness, a reluctance to invest more effort than is strictly necessary. System 2 efforts and self-control help us to overcome intuitions and impulses of System 1.

Mental Effort

For testing of our system 2, we have a game which helps us to know the efforts of our system 2. We prepare a few cards and on which we write the four-digit number. Then we pick up cards randomly and add-1 to each number written on a card. For example, if the number on the card is 1125 then answer will be 2236. We find it easier so now, we can try it with more difficulties and use add-3. That means if the number on the card is 1125 then answer will be 4458. 

Our pupils are sensitive indicators of mental efforts so whenever we put any mental efforts to think our pupil size gets change. When we start working on any problems our pupils get larger in size and as we get solutions or give up then pupil size start contracting.

Switching from one task to another is also requires mental efforts and which uses system 2.

Modern tests of working memory require the individual to switch repeatedly between two demanding tasks, retaining the results of one operation while performing the other. People who do well on these tests tend to do well on tests of general intelligence. We generally tend to break down works in a smaller part to perform it well. We generally use the law of least efforts.

The Busy and Depleted System 2

When we are putting mental efforts means system 2 is busy in thinking so that system 1 take charge of our immediate decisions. If someone asked us to select food during that time, system 1 mostly go with temptation food, go with sweet foods. There can be selfish decisions. Higher the demand for system 2, higher the self-control which is depleting and unpleasant.

Sometimes when we have put efforts in one task, we tend to avoid putting efforts on others. And sometimes, we accept to put efforts on others. When we have a strong incentive to do so.

When you are actively involved in difficult cognitive reasoning or engaged in a task that requires self-control, your blood glucose level drops. So, giving glucose to the brain helps to put more mental efforts. That’s why sweet foods, temptation foods and activities which we love to perform getting demanded when we have put huge mental efforts and we get tired mentally. These things help to give energy and rest to system 2 so that system 2 is getting ready for another mental effort. 

The Lazy System 2

Many people are overconfident in nature and also that have an overconfident on their intuition. So that they avoid taking decision by taking the help of system 2.

When people believe a conclusion is true, they are also very likely to believe arguments that appear to support it, even when these arguments are unsound.

Similarly, while making an investment, we majority times use system 1 and avoid uses of system 2. So, we reach the conclusion and accept the arguments which support our investment though it’s correct or not. Though we have invested wrongly, we do not listen to it and just seek for supporting arguments. 

Those who do not fall under such a trap and uses system 2 whenever required. They are more rational. So that we should not be biased with our investment and keep collecting information which is against our original hypothesis.

This entire series will be review with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.