Nimesh Chanda
In Greek mythology, one comes across a bandit character named Procrustes who lived on The Sacred Way between Athens and Eleusis. Procrustes used to invite tired travelers to his home, give them food and offer them his bed to rest. However, if the travelers were short and did not fit the bed completely, he would hammer and stretch them. If the travelers were tall, Procrustes would amputate the excess length. In either case, the travelers died.
This story of the Procrustean Bed is used to describe how people try to fit facts into a preconceived theory. Researchers have shown that we actively seek out only the information that supports our beliefs or actions and ignore or undermine the information that is contradictory. This tendency affects investment decisions too. It comes in the form of two characteristics of our behavior – Confirmation Bias and Cognitive Dissonance.
Confirmation bias
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Once we make an investment, we actively search for reassurance and confirmation for our actions. We love meeting people who have something good to say about it. This may include other like-minded investors, analysts recommending this particular stock/asset, owners or management of the company etc. We also start noticing every small positive development, no matter how insignificant to our case. New information is also viewed under the lens of existing convictions. This is confirmation bias. Confirmation bias may lead to overconfidence and negligence of the buy-sell discipline. Investors who only look for positive news about their investments are vulnerable to high portfolio concentration or even high leverage. They may miss spotting a change in the business trend or in identifying a mistake in their forecasts. The result? Bad investment outcomes.
How do you counter the confirmation bias?
The antidote to confirmation bias was discovered way back in the 16th Century. During a canonization process (an act by which a Christian Church declares a person as Saint) employed by the Roman Catholic Church, a person is assigned to argue against it. It was this person’s job to take a skeptical view of the candidate’s character and to look for holes in the evidence. The position of this person was known as “Advocatus Diaboli” or commonly referred to as “The Devil’s Advocate.”
Confirmation bias can be managed by having a team member or a friend play the devil’s advocate against the investment decision. We must make sure the person is someone we trust and would act in our best interest. The decision-maker must be mentally prepared to accept the negative findings. So, you must understand that the knowledge about the downside risks to the investment does not make the investment case weak; in fact, it makes it stronger.
Cognitive dissonance
When the new information conflicts with our pre-existing beliefs and decisions, we experience a mental discomfort called the cognitive dissonance. This condition is also known as psychological scotoma – when people are faced with information that is inconvenient to their ego, they respond by turning a ‘blind eye’ to it.
After making an investment, if there is a negative development reported in the company or some other stock comes in as a better option, we have a hard time accepting the new reality. Our mind struggles to rationalize the conflicting information to alleviate this discomfort. Investors can go to great lengths to justify their decisions. One of the most dangerous rationalization statements in financial markets is “this time it’s different.” As a result of cognitive dissonance, investors either add to their loss-making investments or continue holding them as they sink. Many investors also mentally assign the loss to luck or a third party to relieve themselves of the pain. By not accepting their mistake, these investors make themselves vulnerable to repeating them.
How to avoid the pitfalls of cognitive dissonance?
Expecting mistakes, accepting mistakes and learning from mistakes are the way out of this dissonance. Investing is simple not easy; hence expect mistakes. Before making an investment, investors must go through a pre-mortem analysis. If you are buying a stock, imagine that two years hence, (or at the end of your investment horizon) the stock has given a negative return. List down all the things that you think may have led to such a poor return. It is important to do this exercise before taking the action to remain unbiased. Perform a scenario analysis, giving a base case, bear case and bull case with probabilities of these cases coming true. These tools will help the mind expect and accept the mistakes.
Maintain an investment journal where you record every investment decision. When evaluating the outcomes, compare them with your journal and check what worked and what did not. Use your experiences (especially your mistakes) to make an investment checklist. Before making the next investment, refer to the checklist and ensure that you don’t repeat a previous mistake.
Back to Procrustes!
Procrustes continued his reign of terror until he was captured and killed by Theseus, a Greek hero of Athens. The name Theseus comes from the Greek word “Thesmos” which means rule or precept. Taking inspiration from Greek mythology, investors can also use these rules or precepts (like Devil’s Advocate, Pre-mortem, Scenario Analysis, Investment journal and Investment checklist) to overcome confirmation bias and cognitive dissonance.
(The writer is Head-Investments, Equities, Canara Robeco Asset Management)"correct" - Google News
August 03, 2020 at 11:16AM
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A slice of Greek mythology to correct your investment habits - Moneycontrol.com
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