Investing

This post is authored by Puneet Khurana, a Safal Niveshak tribesman.

Are you planning to buy a specific car? Go out and you will start noticing that so many people have the same car. You never noticed it was so damn popular!

Astrology column told you that your lucky number is 999, and miraculously you started seeing that number frequently (house numbers, phone numbers, license plates and even the shares quoting at that price). In fact, you see the number so frequently that you feel the universe is trying to tell you something.

Going through a tough breakup? Sadly, every song on the radio is about heartache. As if somebody told the RJ that you were listening.

Or on a more positive note, you are in love and somehow every song is romantic!

Ever witnessed any of those? If yes, it’s called ‘divine intervention’. Or atleast that’s what we are told most frequently.

On a serious note though, psychologists have a different term for it. It’s called ‘Frequency Illusion’ – the fact that something becomes more frequent in your observation once your mind is introduced to it.

There’s more to it. The phenomenon explained above doesn’t stay in its natural occurrence. Human beings have a natural propensity to take this illusion from its passive existence to an active pursuit and the result is that rather than waiting for things to appear more frequent you start looking for them.

Psychologists call this as Confirmation Bias.

Do you suffer from Confirmation Bias?
Let me explain it a bit more. Even though we like to believe that we are objective human beings with rational thought process, nothing can be far from truth.

Human beings as a species are extremely curious, constantly seeking answers to the puzzles existing in the Universe. But unfortunately, our brain has a very limited circuitry and it’s a natural propensity for us to look for easy answers to complicated questions.

Due to this propensity, the mind has the tendency to jump to conclusions. The first plausible answer that the mind finds to a question becomes the ‘near-truth’ and there is a natural resistance to seek more answers and accept it as a conclusion.

This is popularly known as the ‘first conclusion bias’.

Once this idea/thought/conclusion is accepted by the brain, human beings tend to push aside any other observation which disregards the initial conclusion.

So, if we think about it, our whole thought process since childhood is an outcome of subconsciously seeking out books, writings, evidences in support of the ideas we believed to be true (and disregarding the evidences which oppose it).

Just like a vicious circle, the very act of this selective seeking of supporting evidences makes the initial ideas even more prominent till a point we are absolutely convinced that nothing else is truth.

This is what I introduced above as ‘Confirmation bias’.

Francis Bacon puts it succinctly:

The human understanding when it has once adopted an opinion (either as being the received opinion or as being agreeable to itself) draws all things else to support and agree with it.

Since now you are aware of the two biases, let me come to the big gun.

This one was explicitly mentioned by Munger in his speech – ‘The Psychology of Human Misjudgment’ as ‘Availability-Misweighing’ tendency.

It builds on the two biases explained above and states that the mind, due to its limited capacity, works with what is easily available to it. The things are easily available to mind for variety of reasons.

3 reasons we fall for Availability Bias
Reason #1 – Recent activity: Something which is more recent occupies more recalling power in the brain compared to something that happened long ago and hence we tend to weigh that activity as more important than others.

For example, your tendency to go in a train after a train blast (unless you absolutely have to) is extremely low immediately after a bomb blast.

Similarly our tendencies to avoid areas which had terrorist attacks in recent times despite the fact that the place is safer immediately next day after the blast than let’s say 10 years after it.

Gamblers fallacy is a classic phenomenon explaining this bias because of recent events.

Investopedia defines it this way:

When an individual erroneously believes that the onset of a certain random event is less likely to happen following an event or a series of events. This line of thinking is incorrect because past events do not change the probability that certain events will occur in the future.

For example, consider a series of 20 coin flips that have all landed with the “heads” side up. Under the gambler’s fallacy, a person might predict that the next coin flip is more likely to land with the “tails” side up.

Reason #2 – Personal Experience: Something which has happened to us is easy to recall compared to something which has not. Since your all senses are involved in personal experiences, the impression in the memory is significant and hence it’s easily recallable.

Reason #3 – Vividness: The more vivid the thing, the easier it is to recall for the brain. The technique (vividity) which works as a brilliant memory tool, ironically, also acts as an impediment in logical reasoning due to our tendency to overweigh the importance of a vivid event compared to a ‘not-so-vivid’ event.

Add to all the above our tendency to further look for confirming evidences and we have things so strong that they are most often recalled by our brains during the decision making process.

Some of you might be wondering, “Yes, wonderful, very elegant all this is, but can we please switch to investing and stocks? If you haven’t noticed, this site is called Safal ‘Niveshak’!” 🙂

Well, here it is.

Availability bias and investing
First, let’s understand how an investors ‘suffers’ because of this ‘When-I-am-not-near-the-girl-I-love, I-love-the-girl-I-am-near’ fallacy and then see what can be done to avoid it.

The most common behaviour is observed in the panic/euphoric markets. A recent event causing a sudden reaction in the markets, like a terrorist attack causing a crash are the example of this bias.

At times like these, it is imperative for investors to take themselves mentally away from the scene and think objectively as to why the value should be affected.

We all know that value is affected only by two variables – (1) Cash flows and (2) Interest rates.

If there is no reason for these two to change, there is no reason for prices to change. These markets create opportunities for rational investors. Another way this bias affect us is during the evaluation of business prospect. We have a natural tendency to give too much importance to the current or past few quarters.

The reason is simple, the experience of those quarters is very recent and it’s easy for us to recall that straight away. Combine this with the vividness provided by business channels and experts telling you day in and day out what’s great or bad about the company and that makes you overoptimistic or over-pessimistic about the prospects.

Even the contrarian in you sometimes may feel overwhelmed and succumb to “they must know something I don’t” syndrome.

This can be avoided by taking a longer operating history of the business while evaluating it. Almost every prominent investor has emphasized this fact. Look for a long operating history preferably 10 years or more. In a lot many Indian companies, 10 years history may not be available, but take as much as you can and then evaluate the business.

Important: I am not asking you to ignore the recent quarters. The aberration in recent quarter results may or may not be just aberrations.

Structural changes are also very subtle. But the idea is to look the picture from both far off (10 years) and close (recent quarters) without over-emphasizing any view.

Another way in which availability bias impacts investors is the tendency to give too much importance to an idea (let’s take a stock idea for e.g.), the moment it strikes to us.

The sources of the idea may differ. You may have heard about a company from an intelligent friend or a known stock picker or worse, a TV stock expert and you work on it and you agree with the prospect.

Now don’t get me wrong here! It’s good to be excited about something you just ‘discovered’. I am just pointing out to the fact that the tendency is to give too much importance to the one idea. After all, the stock doesn’t know we own it.

Always remember…

An idea or a fact is not worth more merely because it’s available to you.

The examples are many, like:

• Overoptimistic about upcoming IPO because your previous IPO investment made money, completely disregarding the fact that in general IPOs have been losing propositions for investors.
• Selling a security just because it has risen up substantially in the recent times without giving the regard to the value-price gap.
• Buying something just because it has fallen 80% from the peak. (this is also called anchoring bias but I will discuss it later)
• Giving too much importance to price movement of recent past.
• Giving too much importance to stocks that are covered by the media and ignoring the ones those are not.

And so on…..

But what can rational investors do to deal with this bias?

The solutions have to be customized according to the investor. But here is a general broad guideline which have helped number of investors and which I have found very helpful personally.

Since most of the biases are psychological, unless you are trained to think about them yourself, a written reminder is of utmost use. Infact, we can almost remove all inefficiencies from our thinking process if we follow written procedures (general guidelines).

This idea has been very well explained by Atul Gawande in his book The Checklist Manifesto and the strong idea of checklists have been used and promoted by very savvy investors including Buffett, Munger, Mohnish Pabrai, and Guy Spier.

As a defense against our cognitive disability of remembering everything, checklists help us avoid first conclusion bias. But always remember, the effectiveness of the checklist will be determined not only by its existence but by its exhaustiveness and its ability to accumulate your learning, be it direct or vicarious.

The checklists differ for different kind of investors and the more you read, the more you will be able to develop one. For me personally, checklists serve two important purposes:

1. Since mistakes made in recent investment operations are recallable easily but mistakes done few years back are not, a checklist serves as a reminder to avoid the same.
2. Incorporates not only learning from your own investment operations but also from the other investors’ and hence adds the vicarious learning benefit to your process.

Mistakes are very costly in the markets. There are some mistakes we can’t avoid but some we can. As Buffett have told us a number of times…

An investor needs to do very few things right as long as he or she avoids big mistake.

To do: Don’t do all the mistakes yourself. Learn from others, add to your checklist and follow it religiously. (If possible, I will write a separate post just on checklists considering its importance in the investment process)

Another way of avoiding this bias is not a concrete idea like a checklist but a conscious change in the cognitive thought process.

This is what I learned from Darwin, something he wrote in his autobiography…

I had, also, during many years followed a golden rule, namely, that whenever a published fact, a new observation or thought came across me, which was opposed to my general results, to make a memorandum of it without fail and at once; for I had found by experience that such facts and thoughts were far more apt to escape from the memory than favorable ones.

The idea is extremely powerful and the notion behind it is simple: One can never conclusively prove anything but one can conclusively disprove something.

This is the same idea we use in statistics where our objective is to ‘reject the hypothesis’ or else we ‘fail to reject the hypothesis’. We never accept the hypothesis.

Sighting of 100,000 white swans doesn’t conclusively prove that all swans are white but sighting of one black swan disproves the notion. And hence the idea is to consciously seek disconfirming evidences. As I explained above, it’s our natural tendency to seek out what is consistent with our view. So it becomes absolutely imperative to seek out things which disprove us.

It’s a very powerful idea and so many great investors have made it such a habit that now they do it subconsciously. It becomes the way of operating. And this is not only true for investors, but prominent thinkers, politicians, humanists, businessman and countless successful people.

Some examples where I have used this technique in past:

• Whenever I have a view on a stock, I don’t read the research reports with the similar conclusions. In fact, if I have a bullish view, I make a point to read all the analyst reports which have a sell on the stock and discuss with them, their viewpoint. Remember, there is no right or wrong, just point of views. Right and wrong are always in hindsight.
• When I am studying one school of thought, it’s important to understand other school of thoughts to get the complete picture. I am a proponent of Austrian school of economics but it’s imperative not just to read Hayek or other prominent Austrian economists but also to read Keynes, Krugman etc. to get varied point of views and then decide.
• Don’t assume some strategy work because some investor told you so. More so, why not challenge yourself and read Soros and not just Buffett every time. Or on an unrelated topic, when reading Dawkins work on atheism, you don’t only read Dawkin’s ‘The God Delusion’ but also David Bernilski’s ‘The Devil’s Delusion’.

To do: Have lots of ideas. Have opposite point of views and constantly seek out disconfirming evidence. It’s a very essential trait in a profession where our major enemy against our success is our psychology.

Finally, always remember the wise words of Emile Auguste Chartier…

Nothing is more dangerous than an idea, when it’s the only one you have.

About the Author: Puneet Khurana works with an India focused hedge fund. A student of Prof. Sanjay Bakshi at MDI and a CFA (charter awaited), Puneet is an avid reader of books on investing, finance, psychology, philosophy, physics and various other disciplines.

His investing journey has gone from speculating as a college student to investing based on ‘margin of safety’ principle over a period of 9 years. Currently besides his work, Puneet spends considerable time taking guest lectures in subjects like Investment Management and Business Strategy for MBA students and also training CFA aspirants. He blogs at Pragmatic Investing.

Disclaimer: The views expressed in this post are those of the author only and do not constitute in any way an official position, policy, or pronouncement of his employer.