Influenced in your Thinking by a Bias or Heuristic

Before we start this week’s discussion, I’d like to ask you all to answer the following questions honestly.

You meet a woman and get to know her a bit. She is very quiet and has little interest in other people. She rarely goes out. She is, however, very helpful and knowledgeable. She has an undergraduate degree in English literature from the University of Pennsylvania. Do you think she is (a) A librarian? (b) A sales rep?

You have been gifted $10,000 and bought 100 shares of two different stocks at $50 per share each. Over the next month, one stock plunged to $25 a share while the other one surged to $75 a share. If you have to sell one stock, which do you sell? (a) The $25 stock or (b) The $75 stock

Which claims more lives in the United States? (a) Lightning. (b) Tornadoes.

If I asked you to play a game where I tossed a coin and it landed on heads, I give you $100 and if it landed on tails, I give you $0, would you play? (a) Yes, (b) No.

If I asked you to play a game where I tossed a coin and it landed on heads, I give you $200 and if it landed on tails, you give me $100, would you play? (a) Yes, (b) No.

These are common behavioral finance questions that I’m sure we all are familiar with. Given our educational exposure to BE, I imagine everyone did quite well.

That said, to an investor with minimal background in behavioral finance these questions can tell a lot about a person. I’ll go over the answers at the end.

Let’s start this week’s discussion.

This week we are providing an example of a time when we were influenced in our thinking by a bias or heuristic that was a topic of the readings. I’d like to discuss availability and recency bias, as the two seem to fit together. I’ll also touch upon loss-aversion and how the three work in unison causing serious investment mistakes.

Availability bias is a mental shortcut that causes one to improperly estimate the probability of an outcome based on past personal experience (Pompian & Pompian, 2012). Those of us that suffer from this bias perceive easily recalled past events as being the most likely outcome, when in fact that may not be true. Recency bias causes one to more prominently recall recent events and observations and give them a greater weight in our decision-making capacity (Lamas, 2020). Loss-Aversion is the observation that people, psychologically, find greater discomfort from loss than pleasure from gain (Kahneman & Tversky, 1979).

There is an old adage on Wall Street, stock market tops are a process, stock market bottoms are an event. Stock market sell-offs and “bear markets” are faster and more violent than the typical “bull market” The sudden increase in volatility and asset declines in a market correction can be attributed, in large part, to the above-mentioned biases.

Here are how investors (myself included) are likely to succumb to these biases and why portfolio investment returns may suffer as a consequence. Those of us that have been investing for a long time can recall the flash crash of 1987, the dot.com bust of 2000, the housing/credit crisis of 2008 and most recently the COVID crash of 2020 much more vividly than the simple fact that the S&P 500 has returned an average annual return of approximately 9% since 1980.

A $100,000 investment in 1980 would be worth over $3,000,000 today by just buying and holding an index fund. While making this return feels good, it doesn’t compare to the gut-wrenching experience of those bear market declines. This is a great example of how loss-aversion bias affects our thinking.

So, when the stock market is in the early stages of the topping process, our thinking makes us overly sensitive in the avoidance of that pain from loss. Hence the increased market volatility near market tops.

Then the market starts to drop. Perhaps 5% or 7% from the highs and we start to get bombarded with news headlines about an impending market correction and ensuing economic recession. This is an excellent example of availability cascade as described by Kahneman (2011) as a self-fulfilling cycle that builds upon itself. The greater the media coverage, the more influence on investor psyche – prompting increased media coverage – and the cycle continues.

This is where recency bias comes into play as well. Investors, using the most recent set of events reported by the media outlets will give those opinions greater weight when making investment decisions. This can be an inopportune time to make major changes in one’s investment thesis simply because it is difficult to look from one’s highly emotional state to what would be the most logical outcome on the other side of the experience (Ariely, 2008).

We can prove that this phenomenon exists through various sentiment survey’s that exist. The silver lining to this is that investor irrationality can be predicted and acted upon in many cases, thus providing a means to counter our behavioral biases.

Let’s look at some of the investor sentiment surveys available to us. These institutions go out and take the opinions of investors future outlook for the stock market. The survey’s I will discuss are:

• The AAII Sentiment Survey

• Wall Street Sentiment Survey

• NAAIM Investor Sentiment Index

What I’ve done is taken the last 15 years of each survey and aggregated it into one measure. I then ran the z-score for the model. The way to interpret it is that when the z-score is under -2, then investors are “extremely” negative regarding their outlook towards the stock market.

As it turns out, human emotion can be an interesting market research tool. Over the last 15 years, when human emotion was the most negative towards the stock market, it corresponded with market lows and enormous buying opportunities.

As can be seen in the chart below, there have been 5 times over this time period where investor sentiment bottomed. It happened in 2009, 2011, 2016, 2018, and 2020. These all turned into excellent buying opportunities as the market moved much higher just as investors were feeling maximum mental anguish.

The subsequent market returns after investor sentiment bottomed were:

3/09-5/11: 100%

10/11-6/15: 92%

2/16-10/18: 58%

12/18-2/20: 42%

3/20-9/20: 60%

Kahneman (2011) notes that the neglect of base-rate information is a cognitive flaw and a failure of Bayesian reasoning. It is very easy to succumb to the emotional distress that comes from watching one’s 401(k) become a 301(k).

The reason I administer my behavioral questionnaire prior to investing is to point out the most logical responses to stressful investing conditions while in an environment that is not too stressful under System 1 conditions. That way, there is the possibility to influence System 2 reasoning with sound investment policies (such as, do not liquidate your portfolio when emotional stress levels are peaking).

So, if a potential investor were overly susceptible to the combined forces of availability, recency, and loss-aversion biases, we would have a game plan in place for the next inevitable bear market.

Test Results

1. If you answered (a) in question 1, that is a warning that you may be overly susceptible to availability, representative heuristics & framing. Many folks fall into the trap of stereotyping librarians as quiet and shy and sales reps as outgoing. That said, there are nearly 100 times more sales reps than librarians in the U.S. Based on simple probability, it’s most likely she is a sales rep.

2. If you chose (b), you may be overly susceptible to loss-aversion bias. The total initial investment amount hasn’t changed. Obviously, there was an error in analysis with the stock that dropped to $25. Take the loss and harvest the tax loss. There is also a greater opportunity loss associated with holding the stock that is falling. Another adage on Wall Street, sell the losers, let the winners run. The right answer is (a).

3. If you chose (b), you may susceptible to availability bias. More Americans are killed annually by lightning than by tornadoes. Media reporting exponentially reports tornado fatalities more than lightning fatalities.

4. Almost everyone chooses (a). The only people (at least in my experience) that say they would not play are recovering gamblers and folks where their religion prohibits them.

5. The percentage of people that say they would play this game drops off dramatically. So, if you answered (a) in question 4 and (b) in question 5, then you may be susceptible to loss-aversion bias. After enough tosses of the coin, the end result is winning the same amount of money.

Joseph S. Kalinowski, CFA

Ariely, D. (2008) Predictably Irrational. HarperCollins, New York.

Kahneman, D. (2011). Thinking, Fast and Slow. Farrar, Straus and Giroux, New York.

Kahneman, D., & Tversky, A. (1979). Prospect theory: an analysis of decision under risk. Econometrica, 47(2), 263–291.

Lamas, S. (2020, April 27). Is Recency Bias Swaying Your Investing Decisions? Retrieved September 14, 2020, from https://www.morningstar.com/articles/979322/is-recency-bias-swaying-your-investing-decisions

Pompian, M. M., & Pompian, M. (2012). Behavioral finance and wealth management : How to build investment strategies that account for investor biases. ProQuest Ebook Central http://ebookcentral.proquest.com