The When-In-Doubt-Follow-Others syndrome

This is the 4th post in the “behavioral biases during a bear market” series. You can check out the earlier ones here

  1. Evolutionary roots and our three-in-one brain!
  2. Loss Aversion, Cognitive bias and Pattern seeking
  3. Availability Bias

Choose the correct line?

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Let me start by asking you a simple question?

In the above diagram, which of the three lines numbered A,B and C is closest in length to the target line ?

If you answered C, congrats that is the right answer!

Of course, it was outrageously obvious right.

Now before you swear at me for insulting your intelligence, here is the shocker – in a famous experiment conducted in the 1950’s, for the same question majority of the people chose the wrong line.

But how could this be?

Were they actually that dumb..

Enter behavioral economics. Unknown to the participants, there was a secret behavioral trick played on these people which caused them to choose the wrong answer despite the correct answer being very obvious to them.

If you are curious to learn about this powerful behavioral trick read on..

Enter Mr Asch and his experiments..

In the 1950s, psychologist Solomon Asch invited students to participate in a vision test and the students were split into several groups.

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Now each group was asked a similar question on the lines of –
Which one of A,B,C lines resembled the line on the left?

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But there was a small twist. Only one of the participants in each group was for real. All the others in the group were secretly set up by Asch!

All the participants had to shout their answers aloud in front of the group, but the actors set up by Asch were always made to answer first and the real participant was always the last to answer. In this way, Asch ensured that the real participants listened to everyone’s answers before they gave their own.

During the first part of the experiment, the actors set up by Asch answered the questions correctly and as expected so did 99 percent of the real participants.

But here comes the interesting twist..

In the next part of the experiment, however, Asch secretly asked his actors to deliberately give the wrong answers.

And guess what happened?

When people heard these incorrect answers, they conformed to the majority’s wrong answer more than one-third of the time!

3 out of 4 people ignored what they could see so evidently with their own eyes and answered incorrectly at least once!

You read that right – 3 out of 4 had conformed to the group although they were wrong!

And sadly, only 1 out of 4 could stick to their own views.

The Asch experiment demonstrates that people have a strong urge to conform to the opinion of the group – they would rather be wrong as a group than right as an individual

Everyone is doing it syndrome..

Now while this is an old experiment, scientists have been able to replicate Asch’s results consistently in various other set ups as well. In fact, there is evidence that even chimpanzees have this strong urge to conform.

Also check out this funny video on this pattern repeating in a different context

But why do we conform?

Apparently, we conform for two main reasons:
  1. We want to fit in with the group
  2. We believe the group is better informed than we are

And from an evolutionary perspective, this makes perfect sense..

When our ancestors were living in tribes and clans, they mostly survived by unhesitatingly following the herd, in the absence of better information. Even if the herd was not correct about which way to run to avoid the predator, an individual if he moves away from the herd would make a more easier target on his own as opposed to keeping with the herd.

Further, we are social beings, and what others think about us is remarkably important for us. In our need for a sense of identity we seek to belong and so easily conform with what others are doing.

As the famous investment strategist Michael Mauboussin puts it..
“Humans are social beings, and conformity makes sense in a wide range of
contexts. For example, you are well served to do what others are doing when they know more than you do. Conformity also encourages others to like you, which can confer loyalty and safety. Problems arise, however, when the group is wrong.”  
– Credit Suisse 2015 note (link)

This behavioral tendency of ours to conform with the group is referred to as social conformity or social proof.

Uncertainty is the breeding ground for social conformity..

Social conformity is at its highest especially in situations of uncertainty.

When faced with an unfamiliar or uncertain situation, an unsure individual would feel the need to refer to other people for guidance.

Bear markets + Uncertainty = Social Conformity on steroids

Now if you are wondering on what this has to do with investing – enter the bear market. Uncertainty is at its highest for investors spending sleepless nights wondering how long will the fall last and how steep will it get.

So in uncertain periods like these, the easiest and fairly intuitive option is to look around and follow the crowd.

And unfortunately, the crowd usually panics at exactly the wrong time.

What was a useful trait for our ancestors and for us in several other contexts, unfortunately fails us miserably during a bear market.

So our behavioral enemy no 4 during a bear market is Social Conformity i.e our inherent tendency to follow the crowd.

What is the solution?

Now while the obvious solution is not to follow the crowd, it is far easier said than done. So instead of fighting this urge, we need to play along this urge.

I would suggest finding a group of experienced investors or fellow investors to discuss during times of panic. If this sounds difficult, you can take advantage of the internet and identify your “investors to track” list and follow them closely for their views and interviews.

While the intent is not to follow anyone blindly, staying calm and getting a sense of what the sane and experienced guys are doing will definitely be of some help.

And also keep your what-if-things-go-wrong-plan ready. For details you can refer to my earlier posts here and here

As always in the coming weeks, we shall explore the other behavioral enemies and come up with a solution.

Till then, happy investing as always..

For the rest of us, if you loved what you just read, share it with your friends and don’t forget to subscribe to the blog along with the 3500+ awesome people. Look out for some fresh, super interesting investment insights delivered straight to your inbox. Cheers!

If in case you need any help regarding your investments or want me to write about something, feel free to get in touch at rarun86@gmail.com

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“My wife banned me from riding a bike” – musings of a behavioral finance victim

Recently my wife has banned me from riding my bike. And as weird as it seems, the reason is rooted in behavioral finance. Read on to find out why..

“Bike is banned for me” – your faithfully me (a behavioral finance victim)..

A few weeks back I had written an article here on how to wrap our heads over the fuzzy concept of “risk” in investing. And I had used the analogy of riding a bike to explain my understanding of risk..

This is how it went..

“When we say a higher speed is risky, what we really mean is that if there is some unexpected external event not under your control (say a broken road, an unexpected swerve from the car in front of you, a dog suddenly crossing in front of our bike, a drunkard crossing the road etc) your ability to maneuver the bike is a lot lower at higher speeds and hence the possibility of an accident and the expected impact from it is also very high.”

As fate would have it, I met with a bike accident while on my way to office a few weeks back. Call it coincidence, it was a dog running in front of my bike and crossing the road!

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I crashed into the dog which sent me flying and my bike skidding in different directions.

Since I was wearing a helmet and was at sub 40 km/hr speed the bruises were not major except for a few scratches here and there on my knees and arms.

But unfortunately I got dizzy and went unconscious twice post the accident. My worried folks had me admitted to a hospital and soon we found a doctor who was hinting possibilities ranging from a fracture, a brain concussion to an abnormal ECG reading which meant my heart might need a stent.

And of course, it scared the daylights out of me!

But as we took each and every test, the fracture, the heart issue and brain concussion were gradually ruled out. Several tears down, my wife Shalini heaved a sigh of relief. And I heaved a much bigger one.

This is definitely our most emotionally traumatic 3-4 hours ever.

Once the formalities were done and we came back home, she looked at me straight with a mix of relief and anger and shouted..

“No more bike. Ever! Bloody, start using our car!”

Mind voice of a behavioral finance victim..

Now while I completely get her point of view and I am equally scared on riding again,  here is a little backdrop..

I was wearing a helmet and was going at very reasonable speeds during the accident. And thankfully, the final outcome was a few scratches which have healed now. This is exactly how we want to interpret this whole incident.

But the whole trauma of several possibilities which could have instead played out (further worsened by the inexperienced doctor) suddenly makes the whole activity of riding a bike look a lot more riskier than it actually is.

And here is the scary part – I had done a lot more crazier stuff like riding all the way to Goa, Kerala etc from Chennai with a stupid windbreaker and a cheap knee guard for protection. This included the likes of highly idiotic stuff such as high speeds on unfamiliar roads, sleepless rides, night rides in the ghats amidst pouring rain, absolutely no safety precautions blah blah. And both of us never worried about the risks then.

While I survived all this, finally, a mellowed down “on-my-way-to-office” bike ride finally got me into trouble.

As expected, we suddenly find the whole bike riding activity (a 10 km drive to my office) too risky.

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Now here is the point:

All along there were times where my behavior had been really risky and yet bike riding was still fine. Now when I am a lot more matured in my riding, the sudden accident has made it look a lot more riskier than it is.

I don’t blame us as this is normal human behavior to overestimate the risk post an accident. And yes, behavioral scientists have a name for this behavioral quirk – Availability bias.

Behavioral finance has the answer..

Availability bias is a cognitive bias that lead us to overestimate the importance of information that are most available, more recent, more vivid, that were observed personally, and are more memorable.

Under the influence of this bias, we rarely check the reliability of the information we have readily available nor do we try to search for patterns beyond a time horizon that our memory can serve.

The main reason for this bias is that our lazy brain always chooses the path of least effort. In my case, accessing the fact that for 10 long years, I had thousands of rides and was pretty safe takes quite a bit of effort for our brain and hence we avoid it.

What does this have to do with investing?

Unfortunately the same bias plays out during a bear market. As we have earlier learnt, a bear market puts us under severe emotional stress (almost 2 times our pleasure during a similar upside) and most often than not, we sell out of equities and hope to get back in at the right time.

Now just like my accident, the memory of the emotional stress and market crash is fresh in our brains and it leads to us overestimating the risks in equity market.

Thus we end up staying out of equities for a far longer period as we are still fighting our “previous battle”. And normally the recovery from a bear market is damn swift and by the time we realize, we have missed a huge part of the recovery.

Check out what happened during the initial part of the market recovery from the 2008 crisis.

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This mistake is not jut reserved for the average investor like us but has even happened to experienced fund managers (check the March 2009 cash holdings of equity mutual funds and you will be in for a surprise)

Availability bias spares none!

Thus, availability bias becomes our behavioral enemy no: 3 during a bear market!

Now while it’s too late to prevent my bike ban (as both of us are scared and hope we come over it in sometime), dear reader please take sufficient precaution so that you don’t get banned out of equities when the next bear market strikes.

 

As always in the coming weeks, we shall explore our other behavioral enemies and finally try and come up with a solution.

Till then, happy investing as always..

For the rest of us, if you loved what you just read, share it with your friends and don’t forget to subscribe to the blog along with the 3500+ awesome people. Look out for some free, super interesting investment insights delivered straight to your inbox. Cheers!

If in case you need any help regarding your investments or want me to write about something or discuss regarding professional opportunities in your organization, feel free to get in touch at rarun86@gmail.com

Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments

 

Oops the markets are falling – Spying on investor behavior – Part 2

Exploring the strange habit of selling near the bottom

In our last week’s post here, we had explored how our lizard brains which evolved millions of years ago are still stuck with their primary functions of ensuring our survival and hence end up doing a messy job when it comes to handling falling markets.

Today, we will explore the second behavioral enemy – Loss Aversion

Loss Aversion – Pain from a financial loss is twice the pleasure from a similar gain..

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Behavioral scientists Daniel Kahneman and Amos Tversky have done several experiments to understand how we humans psychologically react to losses vs gains.

Their key finding was that:

  • We all hate losses more than we love gains (duh, didn’t we all know this)

But here is where it gets interesting

The pain  from a financial loss is almost two times the pleasure derived from a similar gain!

  • The result is that investors tend to make poor decisions as a consequence of trying to avoid the pain of a relative or absolute loss
  • This phenomenon is called loss aversion

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Source: Franklin Templeton

So as the equity markets fall, the emotional pain that we experience is much more intense than the pleasure we had earlier experienced from similar gains.

Frequent monitoring of portfolios aggravates loss aversion..

Now as if this emotional pain was not enough, we further aggravate it with yet another behavior of ours – frequent monitoring of portfolios

The advent of mobile apps, has made it much more convenient to track our portfolios anytime, anywhere.

But this has a flip side, as it has been found out that:

The more we evaluate our portfolios, the higher our chance of seeing a loss and, thus, the more susceptible we are to loss aversion

In a market correction usually we are anxious of what if this extends and becomes permanent. This usually leads us to monitor our portfolios more frequently during a market correction (based on anecdotal evidence witnessed from our clients).

Suddenly we have a deadly situation – Loss aversion on steroids!

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The reason why most of us panic and sell during a market correction must be obvious to you by now..

The lethal combination of loss aversion and frequent portfolio monitoring implies significant emotional pain during a market correction. In an attempt to avoid the pain we end up selling our equities.

But wait a minute, are we missing out something..

More than what meets the eye..

Now if this was the case, then most of us must actually end up selling our equities in the initial stages of a correction. However, historically investor behavior during a bear market suggests that majority of investors hang on for the initial part of the correction and usually cave in close to the bottom of the market.

 

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Investor emotions gradually moves across..

Initial stages of fall“It is only a temporary decline. I am in for the long run”

As the fall continues and prolongs“Phew. I give up. Maybe the markets just aren’t meant for me”

What explains this?

To understand this peculiar behavior we need to explore two more behavioral quirks

  1. Our Pattern Seeking Brain
  2. Cognitive Dissonance

Our Pattern Seeking Brain – The desire to see patterns in the market and extrapolate them into the future..

Humans have a remarkable ability to detect patterns. That’s helped our species survive, enabling us to plant crops at the right time of year and evade wild animals. But when it comes to investing, this incessant search for patterns causes more heartache than anything else.” – Jason Zweig

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Our brains are hard-wired to believe we can predict the future and make sense out of random patterns. In fact, it even, it even rewards us for doing so.

Further, according to the author Dan Solin,

The brain of a person engaged in pattern seeking and prediction, experiences the same kind of pleasure that drug addicts get from cocaine or gamblers experience in a casino.

Thus our never ending search for patterns in the equity markets leads us to assume that order exists in the markets. However the harsh reality is that stock markets are far more random and unpredictable than we like to admit.

Let’s put his insight into the current context..

The Indian equity market (represented by Sensex) is down ~10%

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What will happen to the markets going forward? Will the correction continue?

The honest answer is “I don’t know” (an even more honest answer is no-one knows)

But unfortunately our pattern seeking brain is already on to its prediction mode..

All recent market corrections have been followed by a sharp recovery – Taper Tantrum in 2013, China concerns & Oil crash in 2015-2016, Demonetization in fag end of 2016

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So our pattern seeking brain expects the same pattern to repeat this time too.

So we ride out the initial part of the decline as we expect the earlier pattern of quick recovery to repeat. Now if it repeats, well and good. Else we are in for a shock!

Eventually in equity markets, it is only a matter of time before which the pattern gets broken and the market decline prolongs. (but when it happens is anyone’s guess)

And the moment our identified pattern is broken, all hell breaks loose. We panic, our predictions go for a toss and you know the rest of the story –

We end up selling near the bottom!

Let us move on to the second explanation of why we panic close to the bottom.

Cognitive Dissonance: The action-belief mismatch..

The psychological discomfort that we feel when our actions are not aligned with our beliefs is called cognitive dissonance. All of us strive to avoid this as much as possible.
When cognitive dissonance happens, we try to reduce in different ways.

Remember the Aesop’s fable ‘The Fox and the Grapes”..

Driven by hunger, a fox tried to reach some grapes hanging high on the vine but was unable to, although he leaped with all his strength.

As he went away, the fox remarked, “Oh, you aren’t even ripe yet! I don’t need any sour grapes.”

The problem is that in order to reduce the dissonant feeling we can sometimes become biased to self-deception. We can be drawn into simplifying narratives or illusions or become guilty of rejecting valid but contrary viewpoints.

In a bear market, here is how cognitive-dissonance plays out in an investor

Most investors have created a self image of being a good decision maker. They believe they are intelligent and diligent investors and can predict the markets.

Self esteem Paige Soller Flickr

In a falling market, as our investments decline in value, we don’t like to admit that we were wrong. Cognitive dissonance sets in as the new reality – that our investments have declined conflicts with our own view of us being good decision makers.

Selling and realizing a loss only reinforces this and hence we will be reluctant to realize losses even when investment performance is bad. This leads to what is called the “disposition effect.” i.e we stick to our investment holdings despite loss. 

As the market fall continues, the cognitive dissonance continues to increase, but at the same time we cannot sell as it would hurt our ego and self image.

How do we find a way out of this?

As always, we come up with a cunning solution..

Looking for someone to blame

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The solution is simple – Let us put the blame on someone..

“My advisor is a cheat..he should have seen this coming”

“My fund manager sucks”

“The broker recommended me this dud stock”

Phew. Now that we have a scapegoat, we can relax. We suddenly find this a behaviorally easier solution to resolve our cognitive dissonance as we can still can maintain our positive self-image. 

And hence we end up selling, and at the same time manage to keep our self image intact!

Bear market behavior – Complex interplay of loss aversion, frequent monitoring, pattern seeking brains and cognitive dissonance

In the initial part of the market decline, the tendency to sell due to emotional pain from loss aversion and frequent monitoring is negated by our pattern seeking brain (which expects a quick recovery as seen earlier) and cognitive dissonance (which doesn’t allow us to sell to maintain our self image)

But as the decline extends and takes the form of a bear market, the emotional pain pain from loss aversion and frequent monitoring significantly increases. Further the earlier patterns are also broken and we seek to resolve our dissonance by blaming someone else.

As all these factors come together, we usually end up selling near the bottom of the bear market.

This post is not designed to argue that we should not sell equities in a bear market – in fact if the earlier investments were bad it makes all sense to sell out as early as possible.

However if the investments are good and a long term investment strategy is in place, panicking and not sticking to the plan can have disastrous consequences for us.

Thus the idea is to highlight the distinct behavioral challenge that all of us will face in a bear market.

Quick Summary

  • Loss Aversion
    • The pain  from a financial loss is almost two times the pleasure derived from a similar gain!
    • The result is that investors tend to make poor decisions as a consequence of trying to avoid the pain of a relative or absolute loss
  • Frequent Monitoring
    • The more we evaluate our portfolios, the higher our chance of seeing a loss and, thus, the more susceptible we are to loss aversion
  • The lethal combination of loss aversion and frequent portfolio monitoring implies significant emotional pain during a market correction.
  • Pattern Seeking Brain
    • Our brains are wired to seek patterns
    • Our brains are still stuck in the earlier patterns of intermittent declines followed by quick recovery which is common in a bull market
    • The brain expects this correction to be no different and hence doesn’t want to sell right now
    • As the market fall extends, the pattern breaks, we panic and its the same story – we sell close to the bottom!
  • Cognitive Dissonance
    • The psychological discomfort that we feel when our actions are not aligned with our beliefs is called cognitive dissonance
    • Most investors have created a self image of being a good decision maker
    • A falling market conflicts with the self image
    • In the initial part of the fall, we hold on our equities to maintain self image
    • As the fall extends, we remove cognitive dissonance by blaming the poor decision on the advisor, broker or fund manager – and at the same time maintaining our self image
    • Thus we end up selling close to the bottom
  • In the initial part of the market decline, the tendency to sell due to emotional pain from loss aversion and frequent monitoring is negated by our pattern seeking brain (which expects a quick recovery as seen earlier) and cognitive dissonance (which doesn’t allow us to sell to maintain our self image)
  • But as the decline extends and takes the form of a bear market, the emotional pain pain from loss aversion and frequent monitoring significantly increases. Further the earlier patterns are also broken and we seek to resolve our dissonance by blaming someone else.
  • As all these factors come together, we usually end up selling near the bottom of the bear market

Now while there is an urge to come up with a solution to address this, the idea is to explore all other enemies, gain a holistic perspective as we connect the dots and at the end of it come with a solution to fight them all (hopefully).

So I plead patience for a few more weeks.

Till then, happy investing as always

For the rest of us, if you loved what you just read, share it with your friends and don’t forget to subscribe to the blog along with the 3500+ awesome people. Look out for some free, super interesting investment insights delivered straight to your inbox. Cheers!

Disclaimer: All blog posts are my personal views and do not reflect the views of my organization. I do not provide any investment advisory service via this blog. No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments