The Mentality of An Average Investor series will talk about the biases and heuristics of average investors. This series will mostly use interesting surveys conducted by readers to show common misconceptions and biases. Most of the material is taken from the behavior finance course taught by Ling Cen at University of Toronto. Although the entire series are written by me, I would like to credit my professor for the valuable life lessons and investment ideas in this series.
This is part II of the series, if you haven't checked out part I, here is the link.
A decision framing is the decision maker's view and perception of the problem and solution. Framing a question in different ways can trigger different perception of the problem and solution, therefore, affecting the decision.
Consider yourself as the Prime Minister of a country, an unusual disease has landed in your home soil and you are facing with two choices:
Plan A: 200 people will be saved for sure
Plan B: 1/3 probability that 600 people will be saved, and 2/3 probability that none will be saved.
Statistic shows that overwhelming amount of people choose plan A.
Now If I phrase the proposal differently,
The same disease has occurred, but the proposals are:
Plan A: 400 people will die for sure.
Plan B: there are 1/3 probability that nobody will die and 2/3 probability that all 600 people will die.
This time, most people choose plan B over plan A. Objectively speaking, these two are virtually the same choices but yet people make inconsistent decisions. There is something about the word "die" that people want to avoid.
The same happens in the stock market. Investors are often over pessimistic about beaten-down names and companies that do not growth. These boring, value stocks outperform the glamorous growth stocks over any substantial period of time. More information about value stocks vs. growth stock can be found in my other article.
Heuristics is also known as simple rule of thumbs or mental shortcuts. Decision making process can be immensely complicated, people depend on these heuristics to simplify their decision making process. Heuristics are not necessary a bad thing, but sometimes these heuristics are oversimplified and imperfect thus leading people to particular errors.
Decision makers assess the frequency of class or probability of an event by the ease with which instances or associates can be brought to mind. More recent events and more important events will weigh more heavily and distort the estimate. (E.g. The estimated probability of financial crisis in an experienced investors' mind will likely be greater than a new investors who have never experienced the financial crisis)
Familiarity Heuristic: People assume that the circumstances underlying the past behavior still hold true for the present situation and that the past behavior thus can be correctly applied to the new situation. (E.g. In the beginning of 2015, a lot of the analysts were forecasting a quick oil price rebound because it happened both times in the two previous oil declines.)
If a random word is taken from an English text or English dictionary, is it more likely that the word starts with a K or that K is the third letter?
A: The word that starts with K
B: The word with K as the third letter
Answer: The correct answer is B.
Most people choose A, because it is harder to relate to words with K as the third letter.
Availability Bias in the Financial Market:
Retrievable: retail investors will choose investments based on information that is available to them: social network/media
Narrow range of experience: investors choose investments based on their narrow range of life experience(home bias)
Resonance: investors choose investments that resonate with their own personality or have characteristics that they can relate to.
This also extends to geography, language culture and religion.
There are various research papers on how media is influencing share prices:
High media pessimism(optimism) predicts downward (upward) pressure on market prices followed by a reversion to fundamentals, and unusually high or low pessimism high market trading volume.
Source: The Role of Media in the Stock Market, Tetlock
Media coverage predicts cross-sectional returns negatively: higher media coverage, lower returns.
Source: Does Media Coverage of Stocks Affect Mutual Funds' Trading and Performance, Fang and Peress
A more interesting research is the one that Da, Engelberg and Gao published on 2011. The research showed that a high Google SVI (essentially search volume) predicts high stock returns in the following 2 weeks and subsequent price reversal in one year.
Source: Research Gate
We are subject to our heuristics and environment when making decisions. And like making decisions, it is hard to dissociate ourselves from our investments whether that is in terms of personality, geography, or belief. To make better investment decisions, maybe it is better to model ourselves after other successful investors and analysis securities from a point of view of a foreigner.
I believe that studying our human nature and other investors' biases can help us make better investment decisions and avoid pitfalls in our perceptions. In the world of investing, the biggest enemy is likely to be ourselves. I would like to leave you with the quote from Warren Buffett.
It seems to be some perverse human characteristic that likes to make easy things difficult. --Warren Buffett
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.