Cognitively Yours 1.4

 

Raja R, Author

"In the world of investing, being correct and something isn’t at all synonymous with being proved correct right away"

In the previous blogs, we discussed on how mental shortcuts lead to biases which result in sub-optimal investment decisions. We had also seen how fear of regret affects our decision to invest. We had also discussed, how impatience and need for instant gratification make us hardwired to short-term results. How the bias for action leads to not allowing investment to settle and yield rewards. In the world of investing, being correct and something isn’t at all synonymous with being proved correct right away.

We invest and we track our investments. There are times when our investments do well and there are times when it does not do that well. When we track our investments, how do we react to the news or announcements or events affecting our investments. Do we respond too conservatively or react aggressively to the new information? Or we are able to embed the new information in the past data and take a well-informed decision. Let us understand this with a small text book problem on probability.

Imagine 100 bags each of which containing 1000 poker chips. 45 bags contain 700 black chips and 300 red chips. The other 55 bags contain 300 black chips and 700 red chips. The bags are non-transparent. One of the bags is selected at random.

1. What probability would you assign to the event that the selected bag contains predominantly black chips?

2. Now imagine that 12 chips are drawn, with replacement, from the selected bag. These 12 draws produce 8 blacks and 4 reds. How you will use the new information about drawing of chips to revise your probability that the selected bag contains predominantly black chips? If so, what new probability will you assign?

This problem is analogous to a stock or a fund operating in black or red (giving positive or negative returns) in the future? We start out with the initial information that forms the basis of initial beliefs. In this case, the beliefs concern the probability that the bag contains predominantly black chips. The most frequent answer given to the first of the two questions is 45 per cent. The likelihood of stock or fund giving positive returns is less than that it will negative returns. The second question is a bit tricky and complicated. How to react to positive news of the company or stock that has not been performing all that well. The more frequent responses are 45 per cent and 67 per cent - 45 per cent being the number of bags containing predominantly black chips and 67 per cent the fraction of black chips drawn with replacement. Those who choose 45 per cent do not know how to incorporate the new announcement and are hence agnostic to it. They stick to the original beliefs and under-react, as the announcement is favourable to them. Those who choose 67 per cent focus only on the fact that two thirds of chips drawn with replacement are black. They completely ignore the prior information. This is how we react to new events affecting our stock or fund. Either we stick to the old information or overreact to new information without embedding the same in the prior information to have a holistic view. We have taken a case of favourable announcement. The behaviour is same if the prior information is positive and the new announcement is bad. In that case, perhaps, the number of people choosing to act based on the new information could be more. If we do not revise the existing information with new announcement, we may have unexpected surprises in store than we anticipate.