EP52 (Part 1) Cognitive Errors Behavioral Biases
This is volume vesting. I'm your host June Kim in this podcast. You'll learn everything related to volume best. Hello following busters. Welcome to another episode of the value investing podcast on today's show. I wanna talk about behavioral biases, I think this is very important topic for any investors out there. So I hope that this is going to add some value. And what I like to do is. I wanna talk about behavioral biases through three episodes. So on today's show. I wanna talk about cognitive biases from belief perseverance airs on the next episode on talk about cognitive biases from information processing airs. And finally the next on the next episode. We're gonna talk about emotional biases. So I put behavioral buys into these three categories because I thought that it would make sense. And it's. It's gonna be very interesting topic. So before we get into the details. Let me just give you quick. Disclaimer. As always that this podcast is for entertainment purposes, only, and it is your responsibility to consult with your investment professional for any investment decisions. So without further ado what we started. So I wanna talk about the differences between cognitive biases and emotional biases. Because I told you that we're gonna talk about cognitive biases on today's show. And also the next show and emotional biases will be talked about the following episode. What are the differences between these two so cognitive errors can be thought of as blind spots or distortions in the human mind. So it comes from faulty reasoning. You have sub-conscious Manta procedures for processing formation and cognitive errors could arise from that process. And call into airs could be more easily corrected than emotional biases and errors are logically identifiable. So that's the difference between cognitive airs and emotional airs. And emotional airs as the name suggests it's based on your emotions, and even if you know, these things exist, it's probably really difficult for you to stop that from happening. So that's why it's so interesting to talk about because when he comes to investing. What matters is not always the knowledge or logic. What matters is how you can control these behavioral biases, so that you minimize them. But you cannot escape from these biases one percent of time. Even if you are aware of them. That's what makes this things quite fascinating. And I thought that this is very interesting topic to talk about and one thing to note is that among these biases. There are many overlaps. So you can say that in certain situations are one bias is applicable on. And also the other biases might be. Applicable at the same time. So once you learn all these biases, you should be able to understand how you can apply these biases in to real life situations. So let's just talk about them on one by one. And as I mentioned on today's show. I wanna talk about cognitive biases from belief perseverance airs, what that means is that once you have certain beliefs in your mind debt, specific belief is going to persist over time. So it's not easy to change that belief. So let me just list items that we you wanna talk about here. I we wanna talk about conservatism bias second confirmation bias, third representativeness bias and illusion of control bias and lastly, hindsight bias, so these are five items that I wanted this cuss onto this show. I item is conservatism bias, so what is it? Conservatism bias is a belief perseverance bias in which people maintain their prior views or forecasts by inadequately, incorporating your information, so people tend to overweight, initial belief about probabilities and outcomes and on the way new information. So I'm gonna talk about recent seed bias in the future episodes. So it's kind of opposite of that. But here you're basically saying that you tend to put more weight on whatever initially information, they you wire in later, ignore new information. So let me give you a couple of examples here, so many stock analysts invest significant amount of their time to research, their stocks and publish ratings for those stocks. So once they polish. Those ratings they tend to stick with their origin view and only change their ratings when presented with in this beautiful evidence. So they tend to stick with their own views. And this was also has to do some equal because once you say something publicly, it's not easy to change. And once you invest significant amount time doing the now since then, it's not easy to change your view. Even after you received new information that contradicts with your own view. So think about your situation save it. This is applicable for you as well and think about your stock purchasing experience and see if you fall into this trap. But what I like to say is that sometimes it's not always bad to have this bias because if you wanna be a long-term Bester, you wanna have firm ground. Into your analysis. So but also at the same time what this bias is telling you is that you might have to be objective in terms of incorporating. You've us and your information into your analysis. So every now, and then laissez every quarter, the companies publish their quarterly results and every year, they have annual reports, and whenever you have this results and see if you're Alice's has to be modified based on this new formation. That's first thing that I recommend a second. You also need to write down your rationale for any buying decisions. So let's say you want to buy stock. A why? That what you have to do is you have to write down your rationale in protective manner on a piece of paper. So that later if new information comes in then you have to says whether it's important for you to revise your own personal initial assessment of their stock. And you might have to update your rationale on a regular basis. But not too often, as I mentioned, if you think that the information that just came in is probably not worth that much, and it's not material than you probably want to stick with your journal assessment, you strike a balance between sticking with Eurojournal Cessna versus incorporating you information because we are always swamped with tons of information from different sources, and you wanna make sure that return is material and return, his material from owning stock perspective. And if you tend to be vulnerable to all these new pieces of information too often, then also you probably not gonna hold onto your stock. And you're not gonna be alone to invest there. So you'll always have to strike that balance. That's what I wanted to say. Let's move onto the second bias to for today. The second bias coal confirmation bias, this is so prevalent in everyday life. So let me just say what it is. And then give us some examples people tend to look for and notice what confirms their beliefs, and he can or or on the value what contradicts their beliefs. This is a very strong cognitive bias. For example, Republicans watch Fox News, whereas Democrats tend to watch CNN because they want to reinforce their uses team believes they don't want to hear other people's sides. And this is very strong when it comes to politics or religion. And you tend to listen to whatever information that confirms your origin beliefs. Also, let's. Look at investing situation because investors may fall in love with specific stock, and he can no obvious warning signs. So this is quite important because people have this tendency to certain extent, and no matter what can a person you. Are you probably have some tendency of within this confirmation bias space? So let's talk about how we can avoid this confirmation bias, the first thing you can do is actively seek out opposite views. If are long on a certain stock seek out the arguments from short side because they may have a volley points about why you shouldn't hold his stocks. The question that you have to ask is is there something that I'm missing or how do I know that I'm right and others are wrong. Because on every trade there's always opposing side if I'm trying to buy something, then there's always someone on the other side selling the stock. So how do I know that I'm right and the other person is wrong. So that's a question that you have to ask. And also whenever you have this opposite views try to see if they have valid reason and check if also the fundamentals are intact. So whenever this new article or new piece of information comes out and see if it's based on fundamentals of the company or based on something else or emotional selling pressure. And the question that you have to ask is Easter market over reacting to the news. And if the stock goes down, let's say thirty percent on specify news. And you believe that that's not valley. It's probably negative news. But it shoot an actually drive to stock that much than than you. Probably don't have to react to Mr. market's reaction. So confirmation bias as I mentioned is very strong cognitive bias. So you have to play some controls and checks. So that you don't get influenced by a confirmation bias. But I can tell you right off the bat, I have some confirmation bias, and everyone has confirmation bias to certain extent. So our job is not to get rid of all this confirmation bias altogether. I mean, not just confirmation buys all bias. They we're gonna talk about. But our job is cognizant of the fact that these biases exist, but try to cart against falling into trap of making some stupid actions because of this confirmation biases. So let's move onto the next one next one is representativeness bias. So what is it? People tend to classify new information based on past experiences and Klaus fixation people have a shortcut to derive conclusions based on their past experience and intuitions without going through t tail analysis. So this is what we call rule of. Thumb so whenever we apply rule of thumb sometimes it is good because we can make decisions, but sometimes it's not good because his too shallow in terms of doing analysis. So you can take a look at or read a book cold thinking fast and slow by Daniel Canan. And there he describes two systems in our mental system. I system is fast automatic frequent emotional on conscious the second since they may slow infrequent logical and calculating conscious. So these are the two systems that we have and sometimes we can apply system one, which is you know, rule of thumb and shortcut to derive conclusion. Sometimes you you might have to apply system to which which is slower than system on. But requires a lot more time to detail analysis. So it's case by case on I'm not saying that, you know, rule of thumb is bad. But sometimes you have applied both systems in order to derive the right conclusion. So let me give you kick example, many comes to stock market. So a lot of investors up just simply tried to categorize stocks into volume category. When they see low p ratio and low price to book ratio and most cases that rule of thumb works. But not always. So and also when you try to the new management team, all you look at you know, how they talk and how they look and just compare appearance to whatever experience that you have had in the past and tried to SAS their quality based on that based on the first impression. And I think that that's a mistake. So you have to actually look at their track record and look at how they have performed previously on in different companies and so on. So maybe you need some objective data to support your assessment in the new management team. So let me give you some very interesting study by a vanguard investment grew where then allies the five best performing funds from nine hundred ninety four to two thousand three. So it's quite long time period in what they found was fascinating. So Limoges give you quick facts. From this study only sixteen percent of tough five funds made it to the following year's list. So they look at e over year and only sixteen percent of tough five months made it to the following years list. Second tough five funds averaged fifteen percent lower returns in the following year. Third top-five funds barely beat the market in the following year. Lastly twenty one percent of all top five funds ceased to exist within the following ten years. So the reason why I mentioned this study is because people are prone to representativeness bias. So they look at just past experience. And and they look at these top five fund managers than they assume that these top five fund managers is gonna do will again in the future. There so extrapolate the short-term performance of these mutual fund managers into the future. And that's a significant mistake because based on the study these top performing funds cannot really maintain their winning streak in a significant amount of time. There are some exception to this study, for example, Warren Buffett was able to perform very well relative to the market or thirty year period. But usually if you look at this kind of study, it tells you that these top performing funds would not really perform well in the. Future. So they revert to mean. So how do we avoid the representativeness bias? So I think we just have to be objective for any new information coming to us and potentially we can create a checklist. So that we don't actually become vulnerable to our past experiences and biases in classifications we could through this checklist. So that we have a thoughtful way to check. Whether the stock is good or management is good. Okay. So let's move onto the next one. The next one is called illusion of control bias. So what is it people tend to believe that they can control or influence outcomes? When in fact, they can't so let me just give you some examples. When you buy a lottery ticket you choose your numbers. And this is a typical example of allusion of control because people are willing to pay more if they can pick their own numbers. So they they think that they control the situation and they can win the lottery if they pick their own numbers, but in reality, that's not the case, you gonna have exactly the same probability all when you actually let the machine choose the number in the random manner. There's no probability difference between your own numbers and randomly created numbers. So that's typically -xample of losing of control bias. And I there's obvious reason why the lottery company let you do that. Because it actually gives you in of control, and they can make more money off of that. The next example is traders think that they can time the market when they buy or sell securities. And as you know, and I talked this talked about this on multiple times in the past the market is truly random. It's it's a random walk. It's not easy to time the market, but let's say you have some experience in the past to catch the bottom, and you found really right timing and the stock actually has gone up then der experience is going to give you confidence that you can time the market, but that was purely by chance so you don't actually have the control when it comes to price movement in the short term. So don't fall into this trap thinking that you can time the market you can catch the bottom and sell at the top. So I don't think that anyone can do that. So you probably have to forget about the if there's anyone who can do that. Then that person. Should've made tons of money consistently over time. But I have not found any person like that. On the examples dad employees by their own companies stocks on and they think that they can control the outcome of this company. So if you are CEO, maybe this will make sense because but if you're just one of many employees who think that you can control the outcome of companies performance than I think you're fully into trap of illusion of control bias. So how do we avoid this illusion of control bias? Investors need to recognize successful. Investing is based on probability. And they shouldn't really think that they have control, but everything should be based on different scenarios and your sign the probably too stiff these different scenarios and on have the right process to make investment decisions. Always keep track of your investment trading records and assess if you traded up before just because you thought that you could time the market then that was the mistake that you made. Let's move onto the next bias next bias is called hindsight. Bias people may see pass events as predictable and reasonable to expect. And they may say I knew it. I knew that's going to happen. And that's typical case of hindsight. Bias in hindsight poorly reason decisions with positive returns, maybe described as brilliant tactical moves and poor results of will reasoned decisions maybe described as avoidable mistakes. This is where it's important for you to separate process from outcome. Just because you earn a lot of money from a single stock doesn't mean that your investment processes robust. Because you cannot repeat the same thing over and over again, if you Yuli made money based on lock than it's going to be hard to repeat the same outcome over and over again in the future. So if you fall into this bias, then you over is to mate the degree to which you can predict an investment outcome. So how do we avoid this hindsight bias again here, you have to document your investment decisions in terms of catalysts potential, risks and goods and bads? And later when you actually make assessment to your investment decisions when you actually try to SAS how the quality of investment decisions that you have made in the past y'all always look at your initial document and see if your investment outcome directly linked to your origin assessment. Okay. We talked about five different vices today. I hope that it was helpful. So let me just go through them again. Conservatism bias confirmation bias representativeness bias illusion of control bias in hindsight bias. So these are the five cognitive biases from police perseverance airs. So as I mentioned in the intro these other biases that we should card against. But it's something that we cannot completely avoid one of the percent of time because it's just not easy. You're not just why that way. Many consists we probably have to be aware of all these by snus tried to use them to extent possible. But we're not going to be completely free of these biases. I hope that you enjoy this show. It's worth this show. And as I mentioned, I'm going to create more episodes about behavioral biases in the next two words. So thank you very much and soon ext time.