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    August 2012
    M T W T F S S
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    Shortcuts to Ruin

    Alan Fustey

    Shortcuts to Ruin

    “Buy low, sell high” is likely the most widely quoted financial market truth of all time. It makes so much sense, yet it is one of the most difficult tasks to repeat successfully in financial markets. The fundamental assumption of your investment decision making is grounded in the belief that you will rationally make a choice that leads to the highest possible financial gain.

    But is this assumption always correct?

    In order to speed up our decision making all humans utilize shortcuts or rules of thumb, which we use to draw inferences and make decisions from the information we receive. These shortcuts are called heuristics. In many circumstances, these shortcuts are close to being correct, but they also frequently result in some decisions being repetitively wrong. The result is that we are all susceptible to particular types of decision making errors because of our heuristic biases.

    The most common heuristic biases are described below. Can you see how these biases may have affected your past investment decisions?

    Availability Bias – “Trade the News”

    You will predict the frequency of an event, based on how easily the occurrence of a previous similar event can be remembered. If you can remember it quickly, then you believe that it must be important. Therefore, recent events tend to have a greater impact on your decisions than past events and, consequently, recent news is viewed as more important than previous news.

    Most individual investors rely on some type of media reports for a large amount of the information they receive regarding financial markets and investments. The financial media tends to report some types of information frequently because they view it as newsworthy. You will often view more frequently reported information as important and allow it to influence your investment decision making, rather than objectively weighing its relevance.

    Representativeness Bias – “I Will Wait For a Correction to Buy”

    You will regularly make judgments by relying on stereotypes. While this process may be correct in some circumstances, it can be very misleading in others.

    Imagine that you purchase a stock and then watch its price increase for 10 consecutive trading days. What should you do: sell or hold?

    You may believe that you should sell the stock since it cannot possibly rise in price for an 11th consecutive day. Or can it?

    Imagine that you purchase a stock and then watch its price decline for 10 consecutive trading days. What should you do: sell or hold?

    You may believe that you should continue to hold the stock; since it has fallen for so many days in a row any further decline is unlikely. Or is it?

    In both these regularly occurring financial market scenarios, representativeness bias is present and has an influence on your investment decision making process. The fact that a stock has advanced or declined in any previous trading session does not have any bearing on whether it is more likely to reverse direction during the next trading session. Although you should know that this fact is correct, you struggle to overcome the influence of the past on your decisions about tomorrow.

    Hindsight Bias – “I Knew It Would Double!”

    You are inclined to see events that have already occurred as being more predictable than they actually were before they took place. You also tend to remember your predictions of future events as having been more accurate than they were, especially in the cases where those predictions turn out to be correct. Once you learn what occurred, you look back and believe that you knew all along that the result was going to happen. This encourages you to view financial markets as being more predictable than they actually are.

    Hindsight bias develops as you detect new information. Your brain immediately processes the information by incorporating it into what you already understand. This revised understanding then becomes the benchmark from which future information will be evaluated. This process limits your ability to go back in time to objectively assess your state of knowledge at the precise moment that a past event occurred.

    Overconfidence Bias – “I Always Make Money”

    You tend to hold an overly favourable view of your own abilities. As a result, you are overconfident in the reliability of your own judgments to a much greater degree than should be expected based on facts alone. For this reason, you tend to be surprised by an outcome more frequently than you would anticipate.

    We all tend to think that we are better than our peers. In survey responses individuals consistently rate themselves as being above average when they are asked to compare their abilities to a group. Being overconfident is not necessarily a bad personality trait, as it can boost your self-esteem and give you courage to try new things. However, the drawback is that it also leads to overestimating your chances of success or underestimating risks. It leads you to believe that you can control or influence outcomes, when in reality you cannot.

    Overconfidence bias causes you to become too assured about your own judgments and not adequately consider the opinions of others. This false belief in your superior judgment is also linked to a perception that your investment decisions will be less volatile and risky than may actually be the case.

    The MONEY® Network