#011: On Cognitive Bias-Part-I

Jun 05, 2021

Human brain is powerful and there is no iota of doubt surrounding this statement. From inventions that changed the world to theories that shaped our political systems, human brain is capable of accomplishing a lot.

However, our brain still has certain limitations, as it tends to simplify processing of information. This makes our brain susceptible to certain cognitive biases that help you make sense of the world and reach decisions with relative speed.

A cognitive bias is a flaw in your reasoning that leads you to misinterpret information from the world around you and to come to an inaccurate conclusion.

Consider this…

How many times has it happened that objects you own seem to be more valuable to you than they actually are? In most cases, almost every time. For instance, Roohi has a sweater, which her late mother used to wear when she was in high school.

After high school, her mother held onto it. She gave it to Roohi when she joined high school. She wore it a few times. Then, it was Roohi's turn to save it. She hung it up in her closet and it was passed on in the family and the sweater kept moving in and out of the box for years.

But it seems hard to toss it or give it away! It’s too valuable or rather vintage!

This is a classic example of a cognitive bias known as 'The Endowment Effect'

Endowment effect

…is a bias towards the objects we own as being more valuable than the objects we do not own, regardless of the value that market attaches to it.

We humans are hardwired for loss aversion, a survival mechanism that served and helped our species throughout time when food, shelter, water, tools, and the like were difficult to obtain. Because of this loss aversion, or a fear of losing what we have, we tend to place a higher value on things already in our possession. We feel anxious when thinking about giving something away or throwing it out.

Sure, it makes sense if we purchased something and spent our good money on it. Sentimental items are regarded as highly valuable, even though they may not sell for much on eBay or in an auction.

In finance, endowment effect is the main reason that investors tend to stick with certain unprofitable assets, or trades, as the prospect of divesting at the prevailing market value does not meet their perceptions of its value.

How to avoid this bias?

Become Aware: Now that you know that it is hard to let go of something just because you own it, you can be more conscious of your thoughts. Tell yourself it’s the endowment effect trying to grab a hold of you!

Remember Your Whys: If your resolve is low, it’s an excellent idea to write out the reasons you want less clutter. Have these reasons out where you can see them as you are going through your process. Example: Why did you invest in company 'A'?

Opportunity cost: Look out if better opportunities are available and if you are missing out on them only because you are holding onto your previous item.

Now, let's talk about another bias which was very evident in the weeks that went by!

In World War-II, the allied forces wanted to add protective armor to their war planes. As resources were strained, they couldn’t add armor to the whole aircraft. So, experts had to decide which areas were most vulnerable to attack and would benefit most from additional protection.

To decide where to allocate the armor, they studied planes that had been shot but successfully made it back home. They found these planes had incurred no bullet holes to the engine or cockpit, so the obvious train of thought led them to place armor everywhere on the planes except for the cockpit and engine.

Luckily, mathematician Abraham Wald pointed out the flaw in their plan: they were only analyzing the planes that had made it home safely. The location of the bullet holes was not fatal to the planes and, therefore, the aircraft hadn’t been brought down. He recommended the military attach armor to the areas where the surviving aircraft had no bullet holes instead.

By analyzing the planes that had failed, Wald conceived the idea of the survivorship bias —and likely saved many lives.

Survivorship Bias

…occurs when only the winners are considered, and the losers are not. This is to say that the results, or survivors, of a particular outcome are disproportionately evaluated. Those who "failed", or did not survive, might even be ignored. Focusing on the survivors can result in a false, or incorrect, estimation of an outcome.

It is a form of bias in selection of information and can lead to overly optimistic beliefs because failures are ignored.

“Amazon succeeded with this strategy…” “This approach has been working for Facebook for years…” Copying the investing strategies of successful investors often misses the mark. Why is that?

Correlations are not causalities. Just because a particular investor’s investment strategy paid off, it doesn’t mean that this will work for you and may benefit you in the future.

From a business perspective, if you ran a campaign that worked really well in the past, don’t be surprised if it doesn’t perform the same way in the future. User preferences and behaviors change over time meaning you have to stay on top of these changes to roll out campaigns that resonate.

How to avoid this bias?

Ask “why?” more often: How have others managed to do it? How can we achieve our goals? By thoroughly picking through your own results and those of others, you will likely be more successful than by blindly copying supposed success recipes.

Question success stories: Does causality play a role here at all? Could it just be an exception to the rule? How probable is it that you would get the same result if you were to reproduce the approach?

In the recent weeks, if you would have invested in Dogecoin, a popular crypto meme coin, only on the basis of what a particular influential individual tweeted out, then you would have suffered a huge loss.

So the next time you consider selling that old sweater or investing in any asset, don't let your mind fool you!

That’s it for today dear reader. See you next week.

Nash Notes

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