The Psychology of Human

Misjudgment

Read aloud quickly what you see on the screen.Do it twice.

Most of you got it wrong!

Reflexive vs. Reflective Brain.

The reason why people get it wrong is because they “jump to conclusions” using the reflexive parts of their brains.

Reflexive Brain is effortless, automatic, fast, but can lend itself to errors.

Its also the reason why you are alive today. Your ancestors, who learnt to run away at the first sign of danger, were able to increase their chances of survival until at least they pro-created. If even one of your ancestors had died before pro-creating, you won’t be here today. But you are.

Reflexive brain is VERY useful. But it also leads to mistake.

Human Evolution hasn’t kept pace with rapid change since industrialization.

Reflective Brain is effortful, reasoned, slow, logical, and less prone to error

Bias # 1

Availability trap

(WYSIATI)

Assume today is 27 March 2009 i.e. there are only five days left in the

financial year ending on 31 March 2009. One of your

friends has approached you to advice him on his

investments. He presents you with the following data

about his current portfolio:

In addition, your friend also tells you that during 2008-09, he has already realized short-term capital gains of Rs 27 lacs. He now needs Rs 73 lacs by selling part of his portfolio. Which

stocks should he sell?

To a man with a hammer everything looks like a nail

This Data is SO boring!How do we make it more interesting?Enter Chief Constable of Gwent, Wales

Key Word:

GRAPHIC

http://www.youtube.com/watch?v=Q0ukd7xTQ9g

http://www.msnbc.msn.com/id/32657455/

http://www.youtube.com/watch?v=XELamUnF0EU

Approximately 3,000 people died in september 11 attacks.An additional 1,500 died due to increased ROAD Travel because of dread risk.

What caused the dread risk?

The extraordinarily vivid images of the disasters caused mass fear of flying. Key word here is VIVID. But there is a general principle at work here. What is it?

VIVIDNESS can SAVE LIVES

VIVIDNESS can KILL TOO

What’s the general principle at work

What’s the general principle at work here?

Human brains tends to drift into working with what’s easily

available to it.

The human brain tends to drift into working with what’s easily available to it.

“When I’m not near the girl I love, I love the girl I’m near.”

The brain can’t use what it

can’t remember...

...or what it is blocked from recognizing under the

influence of certain

psychological tendencies

The result? Mind tends to over-weigh what’s easily available to it

Tversky-Khaneman video on Availability Bias

“People assess the frequency,

probability, or likely cause of an

event by the degree to which instances or occurrences of

that event are readily “available” in memory.”-Daniel

Kahneman

“An event that evokes emotions

and is vivid, easily imagined, and

specific will be more available

than an event that is unemotional in

nature, bland, difficult to imagine,

or vague.”-Daniel Kahneman

What sort of things tend to

be more available in

our minds than others?

People remember vivid imagesWhich is why this presentation is made vivid

a rich and vivid representation of the outcome, whether or not it is emotional,

reduces the role of

probability in the evaluation of an uncertain

prospect.

On Rare Events

“I visited Israel several times during a period in which suicide bombings in buses were relatively common—though of course quite rare in absolute terms. There were altogether 23 bombings between December 2001 and September 2004, which had caused a total of 236 fatalities. The number of daily bus riders in Israel was approximately 1.3 million at that time. For any traveler, the risks were tiny, but that was not how the public felt about it. People avoided buses as much as they could, and many travelers spent their time on the bus anxiously scanning their neighbors for packages or bulky clothes that might hide a bomb. I did not have much occasion to travel on buses, as I was driving a rented car, but I was chagrined to discover that my behavior was also affected. I found that I did not like to stop next to a bus at a red light, and I drove away more quickly than usual when the light changed. I was ashamed of myself, because of course I knew better. I knew that the risk was truly negligible, and that any effect at all on my actions would assign an inordinately high “decision weight” to a minuscule probability. In fact, I was more likely to be injured in a driving accident than by stopping near a bus. But my avoidance of buses was not motivated by a rational concern for survival. What drove me was the experience of the moment: being next to a bus made me think of bombs, and these thoughts were unpleasant. I was avoiding buses because I wanted to think of something else.”

“My experience illustrates how terrorism works and why it is so effective: it induces an availability cascade. An extremely vivid image of death and damage, constantly reinforced by media attention and frequent conversations, becomes highly accessible, especially if it is associated with a specific situation such as the sight of a bus. The emotional arousal is associative, automatic, and uncontrolled, and it produces an impulse for protective action. System 2 may “know” that the probability is low, but this knowledge does not eliminate the self-generated discomfort and the wish to avoid it. System 1 cannot be turned off.”

“The emotion is not only disproportionate to the probability, it is also insensitive to the exact level of probability. Suppose that two cities have been warned about the presence of suicide bombers. Residents of one city are told that two bombers are ready to strike. Residents of another city are told of a single bomber. Their risk is lower by half, but do they feel much safer?”

The psychology of high-prize lotteries is similar to the psychology of terrorism. The thrilling possibility of winning the big prize is shared by the community and reinforced by conversations at work and at home. Buying a ticket is immediately rewarded by pleasant fantasies, just as avoiding a bus was immediately rewarded by relief from fear. In both cases, the actual probability is inconsequential; only possibility matters.

a basic limitation in the ability of our mind to

deal with small risks is that we either ignore

them altogether or give them far

too much weight—nothing in

between.

Exessive over-reaction vs. Utter neglect.

It depends on “availability”

Terrorism vs. Climate Change.

“It hasn’t happened for a long time, so it won’t happen”Earthquake and volcano eruptions

LTCM It can’t happen to me - like the fellow who goes out on a mobike without a helmet.

“In all my experience, I’ve never been in an accident of any sort worth speaking about. I have seen but one vessel in distress in all my years at sea. “I never saw a wreck and have never been wrecked nor was I ever in any predicament that threatened to end in disaster of any sort.”- E.J. Smith, 1907, Captain, RMS Titanic

How should treat things that have happened before and those that never happened before.

The chances of winning are 10% in urn A and 9% in urn B, so making the right choice should be easy, but it is not: about 30%–40% of students choose the urn with the larger number of winning marbles, rather than the urn that provides a better chance of winning.

The remarkably foolish choices that people make in this situation is called denominator neglect. If your attention is drawn to the winning marbles, you do not assess the number of non-winning marbles with the same care. Vivid imagery contributes to denominator neglect.

When I think of the small urn, I see a single red marble on a vaguely defined background of white marbles. When I think of the larger urn, I see nine winning red marbles on an indistinct background of white marbles, which creates a more hopeful feeling. The distinctive vividness of the winning marbles increases the decision weight of that event, enhancing the possibility effect.

Physicians response to Surgeon General’s report linking cancer to smoking

probability of a

physician smoking is directly

related to the distance of the Her speciality from the lungs!

Before boarding a flight people are prepared to pay more when offered a flight insurance policy to cover against “terrorism insurance” than for a general policy covering all risks.

Clever, psychologically astute insurance companies can use this to manipulate people.

ITS ALL IN THE

Extra vivid annual reports of Temptation Foods (a fraudulent company) resulted in seducing many investors.

QIB Placement on 19 Oct 200776,00,000 shares issued at 150

Money raised: Rs 114 cr.

OUR PRODUCTS

DEVELOPMENTS & INITIATIVES DURING THE YEARRecent Developments

Acquisitions & Investments

AUDITORS REPORT

Text

Now that’s Vivid Too!

Company under several investigations

Moral of the story is that you should be wary of “story” stocks.

use stories to persuade, not be get persuaded by!

Our most recent experience tends to carry more weight in our heads

than old experiences.

Recency

Thats how memory works.

Recent (and also vivid) events.Recency + vividness = lethal combination

And if you get this idea right, you’d understand the importance of taking the opposite view of the crowd when the crowd is obviously wrong.

AFTER the event the RISK went DOWN

Purchase of earthquake insurance increases greatly after the occurrence of an earthquake and declines steadily as the memory of the event fades.

Similar behavior has been observed for floods and food insurance.

Notice this combines with VIVIDNESS

We over-react to recent events

Recency + vividness = lethal combination

The best time to buy is when there is blood in the streets.While I am not a great fan of DCF (more about that later), it is at such times, that thinking in terms of DCF makes sense. The value of an asset is equal to the present value of cash flows. So only a change in two variables can change value. If these changes haven’t occurred but price has crash, this spells OPPORTUNITY

Biggest losing days in stock markets typically mean lucrative opportunities to invest.

First-conclusion bias

The human mind is like the human egg. Out of a billion sperms racing towards the egg, only one succeeds in entering and fertilizing it. As soon as the fastest swimming sperm enters the egg, the egg immediately shuts down to stop any other sperm from entering. We answer questions which start with the word “why” by grabbing the first answer that comes to mind.

Example: Steel Price Hike, Impact on Auto Stocks

Explaining Lollapalooza Outcomes: “part of the reason”

“Nothing is more

dangerous than an idea, when it's the only one you

have.”

Émile Auguste Chartier

If you want to have good ideas, you should have LOTS of IDEAS

Everyone should get a pack of these wonderful cards:

Amazon.com: Creative Whack Pack (9780880793582): Roger Von Oech: Books

The human mind seeks easy

answers to the questions which start with the

word “why”

A stock is selling below cash!

Why should I buy this stock?

Because its cheap!

Well, so what? Under what circumstances would this be a mistake?

Can you think of three reasons why you could be wrong?

You really have to FORCE yourself to come up with 3 reasons which can prove you wrong.

Three reasons why buying it would be a mistake1. Fraud2. Value Trap3. Bubble market

“I followed a golden rule, namely that whenever a

new observation or thought came

across me, which was

opposed to my general

results, to make a

memorandum of it without fail and at

once...

Charles Darwin is a wonderful example, according to Mr. Munger, to study.

“for I had found by

experience that such facts and

thoughts were far more apt

to escape from the memory

than favorable

ones.” - Charles Darwin

I Saw it with my

OWN eyes!!!

Direct Experiences

We overweigh direct experience and under-weigh vicarious experience. What we see for ourselves with our own eyes, hear from our own ears, has a greater impact than what we see or hear through othersI saw it with my OWN Eyes!

Direct ExperienceVs.

Vicarious Experience

Learning comes from two types of experiences.Direct experience

Vicarious Experience is

Safer

The key to success in any field is, to a large extent, a matter of practicing a specific task for a total of around 10,000 hours - Gladwell.

Extreme Success

Extreme Failure

Mediocrity

VICARIOUS EXPERIENCE

Most vicarious Learning Comes from studying extremes

Extreme Success

Extreme Failure

Mediocrity

Copy, Paste,

Emulate

All I want to know is where

I’m Going to Die So I never

Go There

Ignore

Instead of focusing on becoming too smart, I urge

you to focus onavoiding foolish behavior

I urge you to learn from

mistakes of others

“What we learn from history, is that we don’t learn from

history.” Benjamin Disraeli

You will be required to read these books and be prepared to do a quiz (closed book) on it very soon.

Here is your chance to acquire some extremely valuable vicarious experience...

“We have never seen anything like this,” said analyst Glenn Schorr, who covers the investment banks for UBS AG. “There have been tough situations like Long-Term Capital Management and the crash of 1987, but the problem here is there is leverage in the securities under the microscope and in the banks that own them. And to try and unwind it all at once creates a one-way market where there are only sellers, and no buyers.” - WSJ, September 14, 2008

But financial history is littered with examples after examples of similar situations…

This is an example of underweighing vicarious experience.

Just because YOU haven’t seen anything like this, does NOT mean its never happened before.

“But I know a man who smoked three packs of cigarettes a day and lived to be 99!”

If we personally see people who drowned, our assessment of the riskiness of swimming in open waters will be much higher than the correct probability.

Problem of Silent Evidence

You only see the winners!

You can’t learn about success by reading these books because they don’t tell you about the companies who had same attributes but went belly up.

Read “The Halo Effect”

http://www.amazon.com/Halo-Effect-Business-Delusions-Managers/dp/0743291263/

http://www.britannica.com/bps/additionalcontent/18/25996994/Misunderstanding-the-Nature-of-Company-Performance-THE-HALO-EFFECT-AND-OTHER-BUSINESS-DELUSIONS

Stock Market Prediction Newsletter

Scam

One day you receive a newsletter in which you’re offered a free prediction. Reliance Industries would rise by more than 10% during the course of the next month. Coincidentally it does rise by 10%. Next newsletter predicts that Reliance will fall by more than 10% in the next month. A month passes and you notice that the second prediction has also come true.

Stock Market Prediction Newsletter

Scam

six accurate predictions in a row! a coincidence? “Of course not!” you conclude. “This man has real predictive powers.”

364,500 = 1,21,500x3; 1,21,500=40,500x3; 40,050=13,500; 13,500=4,500x3; 4,500=1,500x3; 1,500=500x3.

are there “functional equivalents” of this scam?

Insensitivity to Base Rates (Probability

unconditioned on featured

evidence)

Base rate is the probability unconditioned on featural evidence, frequently also known as prior probabilities. For example, if it were the case that 1% of the public are "medical professionals" and 99% of the public are not "medical professionals," then the base rates in this case are 1% and 99%, respectively.

“Base rates are boring but are amongst the most illuminating statistics that exist.”

100 people - 70 lawyers 30 engineers. When no additional info is provided and asked to guess occupation of randomly selected 10, people use base rates - they say 7 are lawyers and 30 are engineers.

When worthless data is added - Dick is highly motivated 30 year old man who is well liked by his colleagues people largely ignore the base rate in favor of their “feel” for the person.

From “What Works on Wall Street”

When stereotypical info is added e.g. Dick is 30 years old married shows no interest in politics or social issues and likes to spend free time on his many hobbies which include carpentry and math puzzles, people TOTALLY ignore the base rate and bet Dick is an engineer.

Base rates are boring - experience is vivid and fun.

The only way someone will pay 100 times earnings for a stock is because it has a tremendous “story’. Never mind that the base rate of investing in high P/E stocks is horrible - the story is too compelling that people throw base rates out of the window.

Human nature makes it virtually impossible to forgo the specific info of an individual case in favor of the results of a great number of cases. we are interested in THIS stock and THIS company, not with this CLASS OF STOCKS or this CLASS OF COMPANIES.Large numbers mean nothing to us.But they should

instructing people to “think

like a statistician” enhanced the

use of base-rate information,

while the instruction to “think like a

clinician” had the opposite

effect.

Amos and I originally believed, on the basis of our early evidence, that base-rate information will always be neglected when information about the specific instance is available, but that conclusion was too strong. Psychologists have conducted many experiments in which base-rate information is explicitly provided as part of the problem, and many of the participants are influenced by those base rates, although the information about the individual case is almost always weighted more than mere statistics. Norbert Schwarz and his colleagues showed that instructing people to “think like a statistician” enhanced the use of base-rate information, while the instruction to “think like a clinician” had the opposite effect.

“Bargains do appear in the stock market recurrently. However, it cannot be said with certainty that a clear-cut bargain investment

will produce excess investment returns, and it is impossible to predict the pattern, sequence or

consistency of investment returns for a particular bargain investment...

“It can only be stated with certainty that repeated investment in numerous

groups of bargain securities over very long multi-year periods has produced excess returns.” - The

Partners of Tweedy, Browne

You should use Stories to Influence Others

But Think in terms of Base Rates when forming world views

Buffett on technology - why does he keep away (mostly) - the mortality rate of technology companies (averaged out experience) makes him uncomfortable.

He talks about stepping over one foot hurdles vs jumping over five foot ones.

Mortality rates in leveraged stocks

Mortality rates in airline industry

“What we learn from history, is that we don’t learn from

history.” Benjamin Disraeli

Anchoring Bias as a subset of Availability Bias

We need anchors

What are the right anchors?

What are the wrong anchors?

Video Clip on Anchoring

Two different

mechanisms produce

anchoring effects—

one for each system.

Two different mechanisms produce anchoring effects—one for each system. There is a form of anchoring that occurs in a deliberate process of adjustment, an operation of System 2. And there is anchoring that occurs by a priming effect, an automatic manifestation of System 1.

Insufficient Adjustment

“Start from an anchoring number, assess whether it is too high or too low, and gradually adjust your estimate by mentally “moving” from the anchor. The adjustment typically ends prematurely, because people stop when they are no longer certain that they should move farther.”

“Amos and I once rigged a wheel of fortune. It was marked from 0 to 100, but we had it built so that it would stop only at 10 or 65. We recruited students of the University of Oregon as participants in our experiment. One of us would stand in front of a small group, spin the wheel, and ask them to write down the number on which the wheel stopped, which of course was either 10 or 65. We then asked them two questions: Is the percentage of African nations among UN members larger or smaller than the number you just wrote? What is your best guess of the percentage of African nations in the UN? The spin of a wheel of fortune—even one that is not rigged—cannot possibly yield useful information about anything, and the participants in our experiment should simply have ignored it. But they did not ignore it. The average estimates of those who saw 10 and 65 were 25% and 45%, respectively.”

List Price $65,900Average Appraisal:

$67,811

List Price $83,900Average Appraisal: $75,190- a rise of

$7,000

Adjustment is Effortful, System 2

Operation

“Nick Epley and Tom Gilovich found evidence that adjustment is a deliberate attempt to find reasons to move away from the anchor: people who are instructed to shake their head when they hear the anchor, as if they rejected it, move farther from the anchor, and people who nod their head show enhanced anchoring. Epley and Gilovich also confirmed that adjustment is an effortful operation. People adjust less (stay closer to the anchor) when their mental resources are depleted, either because their memory is loaded with digits or because they are slightly drunk. Insufficient adjustment is a failure of a weak or lazy System 2.”

Anchoring as Priming

Effect

Was Saddam Hussain more or less than 155 years old when he died?

How old was Saddam Hussain when he died?

Ans: 70 years.

Did you think of your answer by adjusting down from 155?

And yet the absurdly high number still influenced your estimate.

This is the “power of suggestion.”

Suggestion is a priming effect.

Priming

http://www.youtube.com/watch?v=i1OVhlRpwJc

Primed for Money

“Reminders of money produce some troubling effects. Participants in one experiment were shown a list of five words from which they were required to construct a four-word phrase that had a money theme (“high a salary desk paying” became “a high-paying salary”). Other primes were much more subtle, including the presence of an irrelevant money-related object in the background, such as a stack of Monopoly money on a table, or a computer with a screen saver of dollar bills floating in water. Money-primed people become more independent than they would be without the associative trigger. They persevered almost twice as long in trying to solve a very difficult problem before they asked the experimenter for help, a crisp demonstration of increased self-reliance. Money-primed people are also more selfish: they were much less willing to spend time helping another student who pretended to be confused about an experimental task. When an experimenter clumsily dropped a bunch of pencils on the floor, the participants with money (unconsciously) on their mind picked up fewer pencils. In another experiment in the series, participants were told that they would shortly have a get-acquainted conversation with another person and were asked to set up two chairs while the experimenter left to retrieve that person. Participants primed by money chose to stay much farther apart than their nonprimed peers (118 vs. 80 centimeters). Money-primed undergraduates also showed a greater preference for being alone. The general theme of these findings is that the idea of money primes individualism: a reluctance to be involved with others, to depend on others, or to accept demands from others. The psychologist who has done this remarkable research, Kathleen Vohs, has been laudably restrained in discussing the implications of her findings, leaving the task to her readers. Her experiments are profound—her findings suggest that living in a culture that surrounds us with reminders of money may shape our behavior and our attitudes in ways that we do not know about and of which we may not be proud.”

Speaking of Anchors

“The firm we want to acquire sent us

their business plan, with the revenue they

expect. We shouldn’t let that number influence

our thinking. Set it aside.”

Speaking of Anchors

“Plans are best-case scenarios.

Let’s avoid anchoring on plans when we forecast actual outcomes. Thinking about ways the plan

could go wrong is one way to do it.”

Speaking of Anchors

“The defendant’s lawyers put in a

frivolous reference in which they mentioned a ridiculously low

amount of damages, and they got the

judge anchored on it!”

Money lost in wallet.

Your wallet had Rs 1,000 and now Rs 100 is missing.

You are feeling miserable because you are latching on (anchoring) to money in the wallet and not in the bank. If the money in the bank (your wealth) is large, then this loss is inconsequential.

Stop feeling miserable because of wrong anchors in life...

Par value52 week lowAll time high

Low absolute priceSunk-costs

Stock price itself

Its foolish to think a stock is cheap just because its selling below par or below 52 week low or is selling at an absolute low price.

A stock selling at Rs 5 may be more expensive than one selling at Rs 500.

The right anchor to latch on you is value.

“You’ve got a complex system and it spews out a lot of wonderful numbers that enable you to

measure some factors.

Overweighing what can be counted

“But there are other factors that are terribly important, [yet] there’s no precise numbering you can put to these factors. “You know they’re important, but you don’t have the numbers. Well practically everybody (1) overweighs the stuff that can be numbered, because it yields to the statistical techniques they’re taught in academia. “and (2) doesn’t mix in the hard-to-measure stuff that may be more important. That is a mistake I’ve tried all my life to avoid, and I have no regrets for having done that.”

“The first step is to measure what can be

easily measured. This is okay as far

as it goes.

John Bogle

“The second step is to disregard that which cannot be measured, or give it an arbitrary quantitative value. This is artificial and misleading. The third step is to presume that what cannot be measured really is not very important. This is blindness. The fourth step is to say that what cannot be measured does not really exist. This is suicide.”

“Not everything that counts can be counted, and not everything

that can be counted, counts.”

Albert Einstein

Beta does not capture risk

Beta is easily calculated but is “precisely wrong.” Keynes said correctly: “Its better to approximately right than to be precisely wrong.”

“People calculate too

much and think too little.”

AntidotesLook for

disconfirming evidence – killing

your own ideas

Under-weigh extra-vivid

experience and overweigh less

vivid experience.

Same with recent events; i.e. cool off period after meeting someone very impressive and impressionable.

“Sleep over it.”

“Remember the lesson: “An idea or a fact is not

worth more merely because it

is easily available to you.”

Thank You