Psychology 01 (Nov 08 - Jan 14)

[millionairemind]

Quiet day in the markets.

Behavioral Finance: Key Concepts - Confirmation and Hindsight Bias
By Albert Phung

Key Concept No.3: Confirmation and Hindsight Biases
It's often said that "seeing is believing". While this is often the case, in certain situations what you perceive is not necessarily a true representation of reality. This is not to say that there is something wrong with your senses, but rather that our minds have a tendency to introduce biases in processing certain kinds of information and events.

In this section, we'll discuss how confirmation and hindsight biases affect our perceptions and subsequent decisions.

Confirmation Bias
It can be difficult to encounter something or someone without having a preconceived opinion. This first impression can be hard to shake because people also tend to selectively filter and pay more attention to information that supports their opinions, while ignoring or rationalizing the rest. This type of selective thinking is often referred to as the confirmation bias.

mm comments - are you vested in a stock/company and when everybody is telling you that the fundamentals have changed, you doggedly stick to your views...and only seek out the GOOD NEWS pertaining to your company and filter out all the bad news?? macam like the Class 95FM advert., "ONLY HEAR THE GOOD THINGS".

In investing, the confirmation bias suggests that an investor would be more likely to look for information that supports his or her original idea about an investment rather than seek out information that contradicts it. As a result, this bias can often result in faulty decision making because one-sided information tends to skew an investor's frame of reference, leaving them with an incomplete picture of the situation.

Consider, for example, an investor that hears about a hot stock from an unverified source and is intrigued by the potential returns. That investor might choose to research the stock in order to "prove" its touted potential is real.

What ends up happening is that the investor finds all sorts of green flags about the investment (such as growing cash flow or a low debt/equity ratio), while glossing over financially disastrous red flags, such as loss of critical customers or dwindling markets.

Hindsight Bias
Another common perception bias is hindsight bias, which tends to occur in situations where a person believes (after the fact) that the onset of some past event was predictable and completely obvious, whereas in fact, the event could not have been reasonably predicted.

Many events seem obvious in hindsight. Psychologists attribute hindsight bias to our innate need to find order in the world by creating explanations that allow us to believe that events are predictable. While this sense of curiosity is useful in many cases (take science, for example), finding erroneous links between the cause and effect of an event may result in incorrect oversimplifications.

For example, many people now claim that signs of the technology bubble of the late 1990s and early 2000s (or any bubble from history, such as the Tulip bubble from the 1630s or the South Sea bubble of 1711) were very obvious. This is a clear example of hindsight bias: If the formation of a bubble had been obvious at the time, it probably wouldn't have escalated and eventually burst. (To learn more, read The Greatest Market Crashes.)

For investors and other participants in the financial world, the hindsight bias is a cause for one of the most potentially dangerous mindsets that an investor or trader can have: overconfidence. In this case, overconfidence refers to investors' or traders' unfounded belief that they possess superior stock-picking abilities.

mm comments - When market is in a confirmed uptrend, I am ALWAYS on the lookout for potential signs that this UPTREND will end, ie., signs that it is turning into a correction. Having this "constant lookout for trouble mentality" might help investors/traders this year to avoid big losses

Avoiding Confirmation Bias
Confirmation bias represents a tendency for us to focus on information that confirms some pre-existing thought. Part of the problem with confirmation bias is that being aware of it isn't good enough to prevent you from doing it. One solution to overcoming this bias would be finding someone to act as a "dissenting voice of reason". That way you'll be confronted with a contrary viewpoint to examine.

[millionairemind]

Behavioral Finance: Key Concepts - Gambler's Fallacy
By Albert Phung

Key Concept No. 4: Gambler's Fallacy
When it comes to probability, a lack of understanding can lead to incorrect assumptions and predictions about the onset of events. One of these incorrect assumptions is called the gambler's fallacy.

In the gambler's fallacy, an individual erroneously believes that the onset of a certain random event is less likely to happen following an event or a series of events. This line of thinking is incorrect because past events do not change the probability that certain events will occur in the future.

For example, consider a series of 20 coin flips that have all landed with the "heads" side up. Under the gambler's fallacy, a person might predict that the next coin flip is more likely to land with the "tails" side up. This line of thinking represents an inaccurate understanding of probability because the likelihood of a fair coin turning up heads is always 50%. Each coin flip is an independent event, which means that any and all previous flips have no bearing on future flips.

Another common example of the gambler's fallacy can be found with people's relationship with slot machines. We've all heard about people who situate themselves at a single machine for hours at a time. Most of these people believe that every losing pull will bring them that much closer to the jackpot. What these gamblers don't realize is that due to the way the machines are programmed, the odds of winning a jackpot from a slot machine are equal with every pull (just like flipping a coin), so it doesn't matter if you play with a machine that just hit the jackpot or one that hasn't recently paid out.

Gambler's Fallacy In Investing
It's not hard to imagine that under certain circumstances, investors or traders can easily fall prey to the gambler's fallacy. For example, some investors believe that they should liquidate a position after it has gone up in a series of subsequent trading sessions because they don't believe that the position is likely to continue going up. Conversely, other investors might hold on to a stock that has fallen in multiple sessions because they view further declines as "improbable". Just because a stock has gone up on six consecutive trading sessions does not mean that it is less likely to go up on during the next session.

Avoiding Gambler's Fallacy
It's important to understand that in the case of independent events, the odds of any specific outcome happening on the next chance remains the same regardless of what preceded it. With the amount of noise inherent in the stock market, the same logic applies: Buying a stock because you believe that the prolonged trend is likely to reverse at any second is irrational. Investors should instead base their decisions on fundamental and/or technical analysis before determining what will happen to a trend.

mm comments - A trend is a trend until it bends. That is Y it is NEVER prudent to bottom fish. When STI started crashing from 2800 back in May, some forums I went to have ppe. saying they will buy on leverage when STI hit 2100. Then STI broke 2100, then 1800... finally settling at 1500 before rebounding. It is currently around 1750. Although I did not bottom fish on the way down from 2600, my greatest mistake this year was that I did not SHORT STI when it broke 2400... thinking that the chances of it breaking down much further was limited..... even though having read The Black Swan, I underestimated the impact of the highly improbable

[winston]

The trend is your friend.

If a coin is coming up Heads, bet Heads and continue to bet Heads. The coin is biased so the chances are better if you bet Heads.

The same applies to Roulette ?

[millionairemind]

Behavioral Finance: Key Concepts - Herd Behavior
By Albert Phung

Key Concept No.5: Herd Behavior
One of the most infamous financial events in recent memory would be the bursting of the internet bubble. However, this wasn't the first time that events like this have happened in the markets.

How could something so catastrophic be allowed to happen over and over again?

The answer to this question can be found in what some people believe to be a hardwired human attribute: herd behavior, which is the tendency for individuals to mimic the actions (rational or irrational) of a larger group. Individually, however, most people would not necessarily make the same choice.

There are a couple of reasons why herd behavior happens. The first is the social pressure of conformity. You probably know from experience that this can be a powerful force. This is because most people are very sociable and have a natural desire to be accepted by a group, rather than be branded as an outcast. Therefore, following the group is an ideal way of becoming a member.

The second reason is the common rationale that it's unlikely that such a large group could be wrong. After all, even if you are convinced that a particular idea or course or action is irrational or incorrect, you might still follow the herd, believing they know something that you don't. This is especially prevalent in situations in which an individual has very little experience.

The Dotcom Herd
Herd behavior was exhibited in the late 1990s as venture capitalists and private investors were frantically investing huge amounts of money into internet-related companies, even though most of these dotcoms did not (at the time) have financially sound business models. The driving force that seemed to compel these investors to sink their money into such an uncertain venture was the reassurance they got from seeing so many others do the same thing.

A strong herd mentality can even affect financial professionals. The ultimate goal of a money manager is to follow an investment strategy to maximize a client's invested wealth. The problem lies in the amount of scrutiny that money managers receive from their clients whenever a new investment fad pops up. For example, a wealthy client may have heard about an investment gimmick that's gaining notoriety and inquires about whether the money manager employs a similar "strategy".

In many cases, it's tempting for a money manager to follow the herd of investment professionals. After all, if the aforementioned gimmick pans out, his clients will be happy. If it doesn't, that money manager can justify his poor decision by pointing out just how many others were led astray.

The Costs of Being Led Astray
Herd behavior, as the dotcom bubble illustrates, is usually not a very profitable investment strategy. Investors that employ a herd-mentality investment strategy constantly buy and sell their investment assets in pursuit of the newest and hottest investment trends. For example, if a herd investor hears that internet stocks are the best investments right now, he will free up his investment capital and then dump it on internet stocks. If biotech stocks are all the rage six months later, he'll probably move his money again, perhaps before he has even experienced significant appreciation in his internet investments.

Keep in mind that all this frequent buying and selling incurs a substantial amount of transaction costs, which can eat away at available profits. Furthermore, it's extremely difficult to time trades correctly to ensure that you are entering your position right when the trend is starting. By the time a herd investor knows about the newest trend, most other investors have already taken advantage of this news, and the strategy's wealth-maximizing potential has probably already peaked. This means that many herd-following investors will probably be entering into the game too late and are likely to lose money as those at the front of the pack move on to other strategies.

Avoiding the Herd Mentality
While it's tempting to follow the newest investment trends, an investor is generally better off steering clear of the herd. Just because everyone is jumping on a certain investment "bandwagon" doesn't necessarily mean the strategy is correct. Therefore, the soundest advice is to always do your homework before following any trend.

Just remember that particular investments favored by the herd can easily become overvalued because the investment's high values are usually based on optimism and not on the underlying fundamentals.

mm comments - I did an article on The Anatomy of a Bubble on Aug 24. Few can recognize a bubble when we are in the midst. it's always "THIS TIME ITS DIFFERENT"

So the best course of action - Ride it till it breaks , don't avoid it.
viewtopic.php?f=16&t=610&start=50

[millionairemind]

Behavioral Finance: Key Concepts - Overconfidence
By Albert Phung

Key Concept No.6: Overconfidence
In a 2006 study entitled "Behaving Badly", researcher James Montier found that 74% of the 300 professional fund managers surveyed believed that they had delivered above-average job performance. Of the remaining 26% surveyed, the majority viewed themselves as average. Incredibly, almost 100% of the survey group believed that their job performance was average or better. Clearly, only 50% of the sample can be above average, suggesting the irrationally high level of overconfidence these fund managers exhibited.

As you can imagine, overconfidence (i.e., overestimating or exaggerating one's ability to successfully perform a particular task) is not a trait that applies only to fund managers. Consider the number of times that you've participated in a competition or contest with the attitude that you have what it takes to win - regardless of the number of competitors or the fact that there can only be one winner.

Keep in mind that there's a fine line between confidence and overconfidence. Confidence implies realistically trusting in one's abilities, while overconfidence usually implies an overly optimistic assessment of one's knowledge or control over a situation.

Overconfident Investing
In terms of investing, overconfidence can be detrimental to your stock-picking ability in the long run. In a 1998 study entitled "Volume, Volatility, Price, and Profit When All Traders Are Above Average", researcher Terrence Odean found that overconfident investors generally conduct more trades than their less-confident counterparts.

Odean found that overconfident investors/traders tend to believe they are better than others at choosing the best stocks and best times to enter/exit a position. Unfortunately, Odean also found that traders that conducted the most trades tended, on average, to receive significantly lower yields than the market.

Avoiding Overconfidence
Keep in mind that professional fund managers, who have access to the best investment/industry reports and computational models in the business, can still struggle at achieving market-beating returns. The best fund managers know that each investment day presents a new set of challenges and that investment techniques constantly need refining. Just about every overconfident investor is only a trade away from a very humbling wake-up call.

mm comments - Overconfidence is also part of the reason Y alot of investors will lose money when the market trend changes, cos' they sincerely believe that their superb stock selection skills make their stocks immune to any down turn.

How do you know whether you are overconfident or just plain confident?? just look at your trading account and its returns

[winston]

There's also a very thin line between over-confidence and arrogance. Or are they the same ?

[kennynah]

my take is this...it is very difficult for anyone to objectively assess whether if one has crossed that fine line towards overly confident or even arrogance.

therefore, to ensure we do not suffer as a result of our own psychology, imo, i would trade using a systematic approach. this technical and methodical approach simply removes as much emotional (which is a form of psychology) elements involved in trading/investing...this is my way of mitigating this potential psychological problem...

dont u think?

[millionairemind]

There's also a very thin line between over-confidence and arrogance. Or are they the same ?

W - The line is blurring. I think ppe. can be both arrogant and over-confident. I just think the market is the best judge and if your account is losing money left, right and center, that means you are being too stubborn. But then, it just my 2cts and I am often wrong

[millionairemind]

Behavioral Finance: Key Concepts - Overreaction and Availability Bias
By Albert Phung

Key Concept No.7: Overreaction and the Availability Bias
One consequence of having emotion in the stock market is the overreaction toward new information. According to market efficiency, new information should more or less be reflected instantly in a security's price. For example, good news should raise a business' share price accordingly, and that gain in share price should not decline if no new information has been released since.

Reality, however, tends to contradict this theory. Oftentimes, participants in the stock market predictably overreact to new information, creating a larger-than-appropriate effect on a security's price. Furthermore, it also appears that this price surge is not a permanent trend - although the price change is usually sudden and sizable, the surge erodes over time.

Winners and Losers
In 1985, behavioral finance academics Werner De Bondt and Richard Thaler released a study in the Journal of Finance called "Does the Market Overreact?" In this study, the two examined returns on the New York Stock Exchange for a three-year period. From these stocks, they separated the best 35 performing stocks into a "winners portfolio" and the worst 35 performing stocks were then added to a "losers portfolio". De Bondt and Thaler then tracked each portfolio's performance against a representative market index for three years.

Surprisingly, it was found that the losers portfolio consistently beat the market index, while the winners portfolio consistently underperformed. In total, the cumulative difference between the two portfolios was almost 25% during the three-year time span. In other words, it appears that the original "winners" would became "losers", and vice versa.

mm comments - be very careful of such academic studies.. what constitutes a "winners portfolio"?? Unless it is specified, this can be very misleading. That is the reason Y they are academics cos' they don't invest/trade for a living. Once you are invested with your own hard earned money, it is VERY DIFFICULT to be impartial anymore.

So what happened? In both the winners and losers portfolios, investors essentially overreacted. In the case of loser stocks, investors overreacted to bad news, driving the stocks' share prices down disproportionately. After some time, investors realized that their pessimism was not entirely justified, and these losers began rebounding as investors came to the conclusion that the stock was underpriced. The exact opposite is true with the winners portfolio: investors eventually realized that their exuberance wasn't totally justified.

According to the availability bias, people tend to heavily weight their decisions toward more recent information, making any new opinion biased toward that latest news.

This happens in real life all the time. For example, suppose you see a car accident along a stretch of road that you regularly drive to work. Chances are, you'll begin driving extra cautiously for the next week or so. Although the road might be no more dangerous than it has ever been, seeing the accident causes you to overreact, but you'll be back to your old driving habits by the following week.

Avoiding Availability Bias
Perhaps the most important lesson to be learned here is to retain a sense of perspective. While it's easy to get caught up in the latest news, short-term approaches don't usually yield the best investment results. If you do a thorough job of researching your investments, you'll better understand the true significance of recent news and will be able to act accordingly. Remember to focus on the long-term picture.

mm comments - this I don't agree. This long term crap. The 2008 bear market already showed that you can stay invested from 97 to 2008 and yet at the end of it, have almost nothing to show for it if you were indexing.

[Musicwhiz]

MM, thanks so much for posting this info on psychology, which is also very very important to the investor (whether value or otherwise).

Though our methods differ, I would like to salute you for your methods which I am sure work very well for you.

I would just wish to point out one small point about indexing which you mentioned with regards to availability bias. Most studies conveniently ignore the effects of dividends reinvested or affecting one's long-term return. If we factor that in, it could significantly alter the results of long-term vs short-term (not opining on which is "better" or "worse", just pointing out that we should take this into account when comparing long versus short-term).

Thanks and Happy New Year !