The important heuristic driven biases and cognitive errors that impair judgment are:
2. Over confidence
4. Aversion to ambiguity
Representation or Representativeness refers to the tendency to form judgment based on stereotype. For example, you may form an opinion about how a student would perform academically in college on the basis of how he has performed academically in school. While representativeness may be a good rule of thumb, it can also lead people astray. For example:
1. Investors may be too quick to detect patterns in data that are in fact random.
2. Investors may believe that a healthy growth of earnings in the past may be representative of high growth rate in future. They may not realize that there is a lot of randomness in earnings growth rates.
3. Investors may be drawn to mutual funds with a good track record because such funds are believed it be representative of well performing funds. They may forget that even unskilled managers can earn high returns by chance.
4. Investors may become overly optimistic about past winners and overly pessimistic about past losers.
5. Investors generally assume that good companies are good stocks, although the opposite holds true most of the time.
People tend to be overconfident and hence overestimate the accuracy of their forecasts. Overconfidence stems partly from the illusion of knowledge. The human mind is perhaps designed to extract as much information as possible from what is available, but
may not be aware that the available information is not adequate to develop an accurate forecast in uncertain situations. Over confidence is particularly seductive when people have special information or experience no matter how insignificant that persuades them to think that they have an investment edge. In reality, however, most of the so called sophisticated and knowledgeable investors do not outperform the market consistently.
Another factor contributing to overconfidence is the illusion of control. People tend to believe that they have influence over future outcomes in an uncertain environment. Such an illusion may be fostered by factors like active involvement and positive early outcomes. Active involvement in a task like online investing gives investors a sense of control. Positive early outcomes, although they may be purely fortuitous create an illusion of control.
After forming an opinion people are often unwilling to change it, even though they receive new information that is relevant. Suppose that investors have formed an opinion that company A has above average long term earnings prospects. Suddenly A reports much lower earnings than expected. Thanks to anchoring (also referred to as conservatism), investors will persist in the belief that the company is above average and will not react sufficiently to the bad news.
Anchoring manifest itself in a phenomenon called the post earnings announcement drift which is well documented empirically. Companies that report unexpectedly bad (good) earnings news generally produce unusually low (high) returns after the announcement.
Aversion to Ambiguity:
People are fearful of ambiguous situations where they feel that they have little information about the possible outcomes. In experiments, people are more inclined to bet when they know the probabilities of various outcomes than when they are ignorant of the same.
People have difficulty with numbers. Trouble with numbers is reflected in the following:
People confuse between nominal changes (greater or lesser numbers of actual rupees) and real changes (greater or lesser purchasing power). Economists call this money illusion.
People have difficulty in figuring out the true probabilities. Put differently, the odds are that they don’t know what the odds are.
People tend to pay more attention to big numbers and give less weight to small figures.
People estimate the likelihood of an event on the basis of how vivid the past examples are and not on the basis of how frequently the event has actually occurred.
People tend to ignore the base rate which represents the normal experience and go more by the case rate which reflects the most recent experience.