#012 On Cognitive Bias: Part II
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.
Suppose, you have an important exam tomorrow, however there's this one topic in particular which you haven't practiced yet. Also, you don't have time for it at all. Hence, you decide to go through all the past papers and phone a friend to confirm if this could be the right strategy. Your friend however tells you that it might not be pragmatic, as the person setting up the paper is different.
But you ignore the information because you are confirmed that the questions will definitely come from past papers regardless of anything else. You enter the examination hall and to your surprise the questions are completely different.
Why did this happen?
This is because you decided to hunt for that information (in this case-checking past papers) in particular which made your original argument stronger and deliberately ignore that information (paper setter is a different person) which made your argument or conviction weak. This is a classic example of 'Confirmation Bias'.
Confirmation Bias
… is bias where a person deliberately searches for, interprets, and retains information that matches their preconceived notions and beliefs, only because it makes your brain work a lot less.
In the world of finance and investment, investors deliberately search for information which suits their investment thesis but tend to ignore that information which presents contradictory view points. The result just is a one-sided view and a self-reinforcing loop. Confirmation bias can thus cause investors to make poor decisions, whether it’s in their choice of investments or their timing of trades.
How to avoid it?
Look for contradictory information: It's okay if it makes you question your investment thesis thereby making you uncomfortable, but this will help you a become an intelligent and an informed investor while taking any decision. Question your thesis every time and keep yourself updated with the news so that you could switch when better opportunities are available.
Let's continue further.
In politics, you might have observed citizens to vote for the person who appears to have more popular support because they want to belong to the majority. But why was it so difficult for you to not follow the majority and rather choose your own course of action? This is because of something caused by ‘Bandwagon Effect’.
Bandwagon Effect
…is a psychological phenomenon in which people do something primarily because other people are doing it, regardless of their own beliefs, which they may ignore or override. This tendency of people to align their beliefs and behaviors with those of a group is also called a herd mentality.
The term "bandwagon" refers to a wagon that carries a band through a parade. During the 19th century, an entertainer named Dan Rice traveled across the country campaigning for President Zachary Taylor. Rice's bandwagon was the centerpiece of his campaign events, and he encouraged those in the crowd to "jump on the bandwagon" and support Taylor. By the early 20th century, bandwagons were commonplace in political campaigns, and "jump on the bandwagon" had become a derogatory term used to describe the social phenomenon of wanting to be part of the majority, even when it means going against one's principles or beliefs.
It arises because of…
Groupthinking: When it seems like the majority of the group is doing a certain thing, not doing that thing becomes increasingly difficult.
Desire to be right: People want to be right. They want to be part of the winning side. If it seems like everyone else is doing something, then people are left with the impression that it is the correct thing to do.
Sense of belonging and FOMO: The need to belong, pressures people to adopt the norms and attitudes of the majority to gain acceptance and approval from the group.
How bandwagon effect arises in investing and finance?
Emergence of price bubbles
is something very common in markets.
This often happens in financial markets wherein the price for a particularly popular security keeps on rising. The price can rise beyond a point that would be warranted by the fundamentals, causing the security to be highly overvalued and ends up creating an artificial positive feedback loop of rising prices.
Many retail investors get trapped at the top of the price and when the bubble bursts, the security takes a huge knock on the chin and tanks so much that the losses are very painful.
During the dotcom bubble of the late 1990s, dozens of tech startups emerged that had no viable business plans, no products or services ready to bring to market, and in many cases, nothing more than a name (usually something tech-sounding with ".com" or ".net" as a suffix). Despite lacking in vision and scope, these companies attracted millions of investment dollars in large part due to the same bandwagon effect.
How to avoid it?
Question everything: ask yourself if the price movement is actually supported by the fundamentals and try to find out those things which might be fuelling the rally in prices and ask yourself if it is justified.
Don't jump to conclusions: stay neutral until you have enough knowledge.
So the next time
when you are making an investment decision, look out for contrary information, stay neutral and do your research. Above all have patience and don't do things in a haste.
Also, here is the link to Part-I, if you missed it by any chance.
That’s it for today dear reader. See you next week.
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