Overconfidence
As the name suggested, it is the irrational faith in one’s skills, methodology or beliefs. For example, you see a certain chart pattern and make a maximum leveraged trade, even though you understand that any chart pattern cannot predict market with certainty. Trading excessively after a winning streak also shows overconfidence.
Cognitive Dissonance
It means finding excuses for something which makes you ‘uncomfortable’. For example, jumping from one indicator to another when you face losing trades; or continuing to trade in stock even your trading methodology does not gives you a positive expectancy.
Availability Bias
It means being biased to information which is readily and easily available. For example, people begin to trade using RSI without understanding the internal relative strength; that is, RSI is most talked about on forums so start using them without rationally researching it. Being affected from attractive advertisement or intelligent sounding articles (including this one!) without due diligence also signifies availability bias.
Self-Attribution Bias
It means giving yourself unwarranted praise for outcomes which may just be an outcome of chance. For example, people make money in a bull market through buy and hold and start begin to believe on their trading acumen rather than the market regime which favors their trading style. (more…)
Archives of “cognitive dissonance” tag
rssTrading Madness
| Psychological Bias | Effect on Investment Behavior | Consequence |
| Overconfidence | Trade too much. Take too much risk and fail to diversify | Pay too much in commissions and taxes. Susceptible to big losses |
| Attachment | Become emotionally attached to a security and see it through rose-colored glasses | Susceptible to big losses |
| Endowment | Want to keep the securities received | Not achieving a match between your investment goals and your investments |
| Status Quo | Hold back on changing your portfolio | Failure to adjust asset allocation and begin contributing to retirement plan |
| Seeking Pride | Sell winners too soon | Lower return and higher taxes |
| Avoiding Regret | Hold losers too long | Lower return and higher taxes |
| House Money | Take too much risk after winning | Susceptible to big losses |
| Snake Bit | Take too little risk after losing | Lose chance for higher return in the long term |
| Get Even | Take too much risk trying to get break even | Susceptible to big losses |
| Social Validation | Feel that it must be good if others are investing in the security | Participate in price bubble which ultimately causes you to buy high and sell low |
| Mental Accounting | Fail to diversify | Not receiving the highest return possible for the level of risk taken |
| Cognitive Dissonance | Ignore information that conflicts with prior beliefs and decisions | Reduces your ability to evaluate and monitor your investment choices |
| Representativeness | Think things that seem similar must be alike. So a good company must be a good investment | Purchase overpriced stocks |
| Familiarity | Think companies that you know seem better and safer | Failure to diversify and put too much faith in the company in which you work |
More Research Confirms The Benefits Of Overconfidence
Overconfidence may cause people to invest too much in volatile stocks because such stocks have a greater diversity of beliefs, and so if people dismiss the objectively bad odds of beating the market, such people will be drawn to stocks where they are in the extremum, and highly volatile stocks have the most biased extremums. One might think these people are irrational, but in the big picture people with this bias actually have a huge advantage, why Danny Kahneman said it’s the bias he most wants his children to have.
Two economists at Washington State University looked at twitter accounts for sports prognosticators and found that confidence was much more important than accuracy in generating followers. Their sad conclusion: Pundits have a false sense of confidence because that’s what the public, seeking to avoid the stress of uncertainty, craves. In other words, to be popular (read: successful), you need to be unwarrantedly confident. This takes either an amoral cognitive dissonance or ignorance. (more…)
Mistakes Were Made (But Not By Me)-Book Review
One of the best things I came across this past week was this terrific review by Morgan Housel where he shared insights from the book “Mistakes Were Made (But Bot By Me)” by Elliot Aronson and Carol Tavris. Several members have recommended this book to me so I was very interested to read his review.
According to Mr. Housel, this are the six most important things all of us should learn from this book, many of which are very important to investors and traders alike:
1. Everyone wants to be right and hates admitting the possibility of being wrong.As fallible human beings, all of us share the impulse to justify ourselves and avoid taking responsibility for any actions that turn
out to be harmful, immoral, or stupid. Most of us will never be in a position to make decisions affecting the lives and deaths of millions of people, but whether the consequences of our mistakes are trivial or tragic, on a small scale or a national canvas, most of us find it difficult, if not impossible, to say, “I was wrong; I made a terrible mistake.”
The higher the stakes — emotional, financial, moral — the greater the difficulty. It goes further than that: Most people, when directly confronted by evidence that they are wrong, do not change their point of view or course of action but justify it even more tenaciously. Even irrefutable evidence is rarely enough to pierce the mental armor of self-justification.
2. You brain is designed to shut out conflicting information.In a study of people who were being monitored by magnetic resonance imaging (MRI) while they were trying to process dissonant or consonant information about George Bush or John Kerry, Drew Westen and his colleagues found that the reasoning areas of the brain virtually shut down when participants were confronted with dissonant information, and the emotion circuits of
the brain lit up happily when consonance was restored. These mechanisms provide a neurological basis for the observation that once our minds are made up, it is hard to change them. (more…)
HUMAN MISJUDGMENT- 22 Points
1. Under-recognition of the power of what psychologists call ‘reinforcement’ and economists call ‘incentives.’
2. Simple psychological denial.
3. Incentive-cause bias, both in one’s own mind and that of ones trusted advisor, where it creates what economists call ‘agency costs.’
4. This is a superpower in error-causing psychological tendency: bias from consistency and commitment tendency, including the tendency to avoid or promptly resolve cognitive dissonance. Includes the self-confirmation tendency of all conclusions, particularly expressed conclusions, and with a special persistence for conclusions that are hard-won.
5. Bias from Pavlovian association, misconstruing past correlation as a reliable basis for decision-making.
6. Bias from reciprocation tendency, including the tendency of one on a roll to act as other persons expect.
7. Now this is a lollapalooza, and Henry Kaufman wisely talked about this: bias from over-influence by social proof — that is, the conclusions of others, particularly under conditions of natural uncertainty and stress. (more…)