Behavioral Bias In Markets – Part 1

My favorite topic for weekend reading is on behavioral finance. Authors like Kahneman and Mauboussin are my favorites as are various blogs on the Net on the subject. I am convinced that almost all of our errors in the market are owing to the working of some bias or the other. These are so inherent in our behavior that we seldom realise when they kick in. It is almost automatic. The problem is that our brains are so good at performing these functions — they slip into these patterns so quickly and effortlessly — that we end up using them in situations where they don’t serve us. I don’t have solutions to these but I do believe that becoming aware of them would be the first of the steps towards eradicating them (if we truly can) from our psyche.

I was introduced to the term Survivor bias by one of my former associates, Prashant. A voracious reader with a super memory to boot, Prashant told me about survivorship bias when we were discussing the components of the Nifty. I read about it and find it being applied almost everyday in the markets in various ways. Chief among them is in the mid cap zone where a stock has run away big time. Now, at some point of time in the career path for a big mover, you would have heard or been told about it. You didn’t buy it – for whatever reason- and then when you notice it later, it is quite a bit higher. When you hear it again, it is considerably higher. Now you cant take your eyes off it. Naturally, it continues even higher, inflicting emotional pain of non-participation in a situation that you could possibly have. You rue, lament and curse yourself. What you are not seeing, however, is that just at the time you were told about this stock, you also heard about ten others, equally convincing stories, which too, you didn’t buy. But those ten others did not perform and only this one did. The media covers only this one. Research reports are published about only this one. The other ten are lost in the market maze. This is survivor bias making you think that you COULD have done it- buy and hold a winner. Chances are very bright that you bought a lot of others and they did not perform, at least not as well. Those look like mistakes to have avoided but the dominant thinking is that you COULD have done the right thing. Survivor bias is a great error that makes you think that you are more capable than you really are.

Where can survivor bias impact is in daily lives in markets? One thing to do is not to look at stocks that have run away in a sector or a subsection of the market and rue that you could not do it. Remember that you are attracted to this only because of its survivor nature. It is one among the hundreds that can potentially move in the market. While you are getting lost in the charms of the survivor, you may be losing out on attention on so many others that can create potential winners for you. Worse, regretting not getting into the surviving winner may incapacitate you from seeing other potential winners. This is because your entire frame of reference gets thrown off. Just because Force Motors ran up big time is no reason for SML Isuzu to do so. If IMFA has flared up, you cannot expect Factor (a sick unit) to do so too. But this is how we tend to think. One of the biggest contributors to such thinking is survivor bias.

We will take up more biases in future articles. Until then check yourself about tendency to give in to survivor bias and try to correct the effect it has in your choices of stocks and timing of your trades and investments.