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.
Before starting, if you missed the previous editions of our Cognitive Bias series you can read them here:
Part-I
and
Part-II
Try to recall the time when you didn't do well on a test. What was the reason? Did you perform poorly because you didn't study hard enough? Or because the questions were unclear and it was sheer bad luck? Chances are that you blame the latter because of not doing well on a test.
On the contrary, if you do perform well on a test, it is highly likely that you attribute your success in the test to your hardwork and ignore the "luck" factor, which you did not in the previous case. This is a classic example of self attribution bias.
Self attribution
…bias is a human tendency in which failures are attributed to bad luck and things not under your control. Whereas, success is attributed to personal skills.
Self attribution bias can lead to overconfidence and constantly attributing negative outcomes to external factors can lead to low levels of self awareness and lower scope for self-improvement. In some cases, it can also lead to bad relationships with colleagues.
In finance and investing, this particular bias will lead to bad investment decisions as it limits our understanding about what actually happened. There can be a whole host of reasons why we’ve had a particular success or failure in the financial markets.
How to avoid this bias?
Maintain a journal: Keep a record of everything in a journal. Reviewing a well-kept journal and assessing it timely will help you spot strengths and weakness of your investment decisions. It can also help you identify when and why your analysis was right or wrong.
Accept your mistake: It’s important to acknowledge when we have followed faulty reasoning that led to a bad outcome. It is only through admitting and examining our mistakes that we can learn from those mistakes. And it’s only through recognizing when we’ve fallen victim to things such as the self serving bias that we can learn to avoid such thinking traps in the future.
"Human beings aren't rational animals; we're rationalising animals who want to appear reasonable to ourselves", said the famous social scientist, Elliot Aronson, author of 'The Social Animal'. As human beings and in particular, social beings, we use stories to make sense of our world.
Storification bias
Stories are much more powerful and memorable - hence satisfying to us. This leads to a bias known as Storification Bias.
Investing is something very new in history. And, when that same instinct, the same way of thinking, the same biases and quirks – of the Stone Age man - come into play while putting in money in a company, they can change outcomes dramatically.
In investing, this bias occurs when a fund manager weaves a good story about a company's brand value and customer relationship. This could impress you to invest. But once you invest, you have the market, and not a human, on the other side. And the market does not care about the story you were told.
Let's take an example...
It is highly likely, that we are on a cusp of a big technological development in the fields of Artificial Intelligence, Machine Learning, Internet of Things and much more, which could be termed as "Industrial Revolution 5.0"
Thinking about this, you plan to invest in a company which works in the same field. However, what is the guarantee that the particular company will still fetch you good returns? As you might already know that any company's performance depends on market evolution, competitor growth and customer evolution among other parameters and, therefore, it cannot be contained in a single story.
While making decisions about your money you should try to make yourself aware about the various probabilities and possibilities, and not believe in a simplistic story regarding an investment opportunity.
Since 1992-2020, Coca-cola has give an average CAGR of close to 8% while Pepsi has given an average CAGR of close to 13%. Majority of us are aware of an ace investor who has been holding stocks of Coca-cola since so many years but he was unable to dilute the investment even as the returns were low, why did this happen?
Because he had storified this stock and its management massively and publicly.
In India, you would have heard the talk that you cannot go wrong buying 'blue chips' or consumer stocks with strong brands, moats and cash flows that are predictable for decades? This story is seductive and untrue.
Ever heard of Gillette India, ITC and Colgate? They used to be part of this list of storied, branded consumer companies, till their stories went sour (future might be bright, who knows?). And very quietly, they went out of the list of these so-called Compounders.
Thus, even if you believe that the story is plausible, it is still important for you to recheck your thesis on investing time to time and look for changes in the industry and in the company too.
That’s it for today dear reader. See you next week.
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