Daniel Kahneman has split the brain into 2 systems of thought: one intuitive (System 1), the other reflective (System 2):
System 1 operates in automatic mode, requiring no effort. It operates by association of ideas: an image or a word triggers an idea, then others in a cascade. For example, it enables us to identify familiar situations and deduce appropriate behaviour. These associations are consistent with each other, but they do not form logical reasoning. This instinctive way of functioning is very efficient for carrying out our everyday tasks, but because it operates too quickly, it is the source of illusions and biases.
System 2 is logical. It's what makes it possible to carry out complex tasks, and it's what you call on when you try to calculate 34*57. However, system 2 has one big flaw: it's lazy. When system 2 is triggered, it conflicts with the first system. To check this, take a walk with your friends. This mechanical walk is operated by system 1. During this walk, ask your friends to calculate 34*57. They will probably feel obliged to stop walking to answer your question.
Once we've understood how our 2 brain systems work and identified the problem for each of them, it's not surprising to realise that even important decisions like investing in the stock market are subject to mental biases and heuristics. In the next sections, we will try to list the biases and heuristics that humans use most when it comes to financial investment and explain how our product Market Buzz can help to fight them:
1/ Anchoring bias
We can find 3 trivial applications of the anchoring bias in our investment decisions.
The first one intervenes before entering a trade. For instance, when we watch a share price rise in real time (tick by tick), we anchor the immediate momentum in our heads and have the impression that the price can only go up. The more the investor looks at the order book in the very short term, the more prone he is to this bias, making it more likely that he will execute a buy order when he sees the price going up (whereas it would be better to take advantage of a downturn to get in on the cheap).
The second one operates once a trade has been initiated. Thus, the investor anchors his/her entry price and will tend to take action (close a trade for instance) if the share price falls back below it because loss is painful (regardless of whether the share is testing support or if the price has not reached the stop-loss he/her had previously defined).
A third one develops after the trade has been closed. Indeed, we anchor the closing price and it will be difficult to initiate a new 'buy' above this closing price, having had the impression of we should have held the position, even if the stock still has significant upside potential.
How can Market Buzz help you fight against this bias? The ‘Trend Analysis’ widget lets you take a step back from the stock's chartist situation and avoid overreacting to a very short-term change in the stock you are monitoring.
Example:
if you hold a position on Blackrock, this analysis will help you not to overestimate the recent correction move (from 1080 to 900) and to keep your position. In addition, we also provide you with the threshold (in blue) at which we consider that the technical situation is changing, and therefore at which it seems reasonable not to persist or risk greater losses.
2/ Substitution bias and the affect heuristic
They often work together. Substitution bias consists of answering a complex question by answering a different, simpler question, often linked to an emotional heuristic (switch from System 2 to System 1 (Remember: System 2 is lazy)). Let's take an example: to determine whether Ferrari's share price is going to rise or not, many parameters need to be analysed (internal to the company, such as sales, company debt, etc., or external, such as customs duties, competition, etc.). This is very complicated, time-consuming and therefore where the idleness of system 2 comes to the fore. All these questions will often be replaced by a shortcut : ‘Anyway, I think Ferrari makes nice cars, I'd like to buy one, so I'd like to own several of their shares’.
A combination of the 'Most Discussed Topics' (MDT) and the ‘Mentions Sources’ widgets can help your system 2 to keep working by not only pointing out the side of the company you should focus on but also by structuring its buzz between News, Web & Social Media, revealing whether the company's buzz is just a fad or not.
Example:
On Astrazeneca, you can see that news was not retrieved from social medias. So, the current acquisition, highlighted by the Most Discussed Topics, is to be taken seriously.
3/ Hindsight bias
Hindsight bias is the tendency to overestimate our ability to predict the outcome of an event after it has happened (The famous ‘I knew it!’). This forms a kind of illusion of predictability which can lead us to believe that we can anticipate the future better than we really can (some variations are just due to randomness), leading to overconfidence and poorly calculated risk-taking. For example, 6 months after investing in a share, the investor sees the price rise. The investor then thinks that the success was obvious from the outset and will strengthen hi/her position, whereas the company's situation has not improved (or may even have deteriorated, the stock having just benefited from a market effect). Self-attribution bias is common among both experienced traders and novice investors. It generally takes the following forms: ‘My investment has increased because I am good at investment research, I can analyse financial figures and I can distinguish good investment decisions from bad ones’, or ‘My investment portfolio has decreased significantly due to unexpected high volatility in the market and unpredictable macroeconomic conditions.’ The portfolio management success belongs to me, while the investment failure is due to someone else. This attitude deprives investors of opportunities to learn from past mistakes and makes them falsely confident of their ability to predict the future. In more practical terms, unwarranted overconfidence leads to excessive risk appetite and overtrading, resulting in a poorer relationship between risk and return. It can also lead to poor portfolio diversification.
The Peer Comparison, News Feed & MDT sections can help you to identify the nature of the variation in your investment (sector effect, market effect, specific news, capital transaction, quarterly results, change in recommendation, etc...) and thus avoid attribution errors.
Example:
Thanks to our News Feed, you can see here that the 15% increase in Clariane's share price is due solely to a change in broker recommendation and not to any structural shift in the company (such as an acquisition or newly impressive financial forecasts). This kind of situation should prevent you from increasing your exposure.
This behaviour often precedes overconfidence (see below).
4/ Overconfidence
A characteristic of overconfident investors is excessive trading. Whereas the rational investor only makes an investment when the profits exceed the transaction costs, the irrational, overconfident investor overestimates the profits and underestimate transaction costs, which ultimately turn out to be negative.
Our ‘Sentiment History’ widget can help you avoid overvaluing a news item and overtrading in a period when you are more optimistic or pessimistic than you should be by replacing the interpretation of stock news in relation to a benchmark of pessimism or optimism.
Example:
Here, on JMAT LN, you can read about a new patent application that could boost share prices. However, you can also see from our historical sentiment that this news does not trigger any optimism among investors (the blue area means "Neutral") and is therefore unlikely to trigger any new bullish momentum, preventing you from taking an undesirable position.
5/ Home country bias
In finance, this bias leads people to invest in assets they know well (here, investors are going to make their system 2 work, but only to a limited extent), which means their portfolios are less diversified than those of someone who does not suffer from the same bias, making their portfolios riskier, less diversified and more likely to suffer losses.
Market Buzz is available on multiple markets, not just your local or home market.
6/ Group effect
The group effect is one of the best-known biases and allows us to operate our system 1 without feeling guilty. It is the tendency to follow the behaviour of others, without adopting a rational approach that would enable us to make an informed choice. The group effect can lead, for example, to selling a share just because everyone else is getting rid of it, even if this is not necessarily the right choice. Similarly, you could buy a share by following the euphoria of others, with the risk of hitting a speculative bubble.
By combining the ‘Sentiment Score’ and ‘Subjectivity’ widgets, you can foresee a blow-off or sell-off situation, avoiding the pitfalls of buying at the top or selling at the bottom. In fact, an exaggeratedly positive/negative sentiment score coupled with an equally high subjectivity index should alert you to the irrationality of the situation.
Example:
Sentiment here is at levels rarely seen (at least not for almost 6 months, as the sentiment history line shows) and, above all, these levels of optimism appear to have a high threshold of subjectivity, making this euphoria suspect... The stock is poised to open with a 4% bullish gap over its all-time highs of around $47 (premarket level on March 21st): Bull-trap? Are the last buyers entering the trend? In any case, the combination of widgets in our product allows you to approach these situations with wisdom and hindsight.
7/ Confirmation bias
The investor wants to make a ‘killing’ and enter into a speculative stock. He/She will then look for any argument likely to confirm his/her opinion and will automatically discard contradictory information. For example, when investing in a company in difficulty, the investor might focus solely on the aspects that seem promising, such as growth potential, while ignoring the underlying financial problems. Confirmation bias also operates once a trade has been initiated. Thus, initially, the investor may have analysed the situation correctly, but will refuse to see it change and will dismiss any information that might make him/her change his/her mind. Conversely, he/she will look for any argument likely to confirm his opinion.
Market Buzz is devoid of emotion. Our ‘News Feed’ thread will not play down any information and will present news perceived as positive or negative in the same way.
8) Availability bias
Question: in your opinion, is it more likely to be killed by a shark attack or by a falling asteroid? Instinctively, we're more afraid of dying in the teeth of a shark than of having a cosmic stone dropped on our heads. Yet according to researchers at the University of Florida, the chance of being killed by a shark is only one in 3.7 million, whereas the chance of dying from a falling asteroid is one in 1.6 million. So why this phobia of being attacked by a shark? Quite simply because each attack is generally recorded and reported by the media. It follows from the above that the more information is reported, the more we tend to believe that the risk of occurrence is frequent. Thus, in behavioural finance, we will wrongly favour (buy or sell) the securities for which the information is most prevalent. Investors will base their analysis on readily available information (advice from friends, advertisements, newspaper articles, etc.) without really checking the fundamentals of their analysis conscientiously. Investors will generally prefer stocks they think they know best, based on their life experience, their profession or the friends they associate with. The risk here is clearly a lack of portfolio diversification.
How can Market Buzz help you fight against this bias? Market Buzz covers thousands of stocks well beyond your geographical area, your business sector or your network.
9) Status quo bias
It's a well-known fact that it's always easier and more tempting to put off important and difficult decisions until later (system 2 is adept at procrastination ). This is the status quo bias - the tendency to leave things as they are, with any change appearing to bring more risks and disadvantages than potential benefits. In behavioural finance, the fear of making bad decisions or incurring losses can paralyse investors. They may hold on to investments in their portfolio that are no longer at all suited to their view of risk, or hold on to securities that they like but which are detrimental to them.
The ‘Confidence Index’ widget - by gathering the volume of news evidence backing the sentiment score, indicating how much trust can be placed in it - will help you to avoid over- or under-valuing a situation, making your intervention (or hands-off) more effective.
Example:
In this example, we are detecting a stock - Energean - that is buzzing and whose sentiment seems to be positive. But on closer inspection, what we see is that the level of confidence is low and that the prevailing optimism is based on very little news. What's more, technical analysis is pointing to a bearish forecast. So, in this case, your non-intervention is not due to status-quo bias, but to well-founded reasoning and the use of your ‘System 2’, so that you can avoid taking a position and suffering the 10% fall in the price on 17 March.
10) Illusion of control
It has been shown that investors who look at their portfolios too often are much more likely to lose money than those who consult them more occasionally. This stems from the illusion of being in control of a situation: by keeping a close eye on your investments, you think you are in better control of your finances, but you also perceive much greater portfolio volatility, which can lead to bad decisions.
Our product warns you only when necessary (you can filter by top buzzing situations), combating infobesity, saving screentime and avoid overtrading.
11) Framing effect
The framing effect is a cognitive bias that describes how individuals' decisions and choices are influenced by the way in which information is presented or 'framed'. This bias suggests that the way in which a message or option is presented can have a significant impact on how individuals perceive information and then make decisions, even if the underlying content remains the same (trapping your system 2). To illustrate the framing effect, here is an example:
Option 1: In Q2, EPS were $1.25, compared to expectations of $1.27
Option 2: In Q2, EPS were $1.25, compared to Q1, where they were $1.21
Clearly, option 2 provides a greater incentive to buy than option 1
On our side, we are independent and have no interest in presenting a company's news from one angle rather than another. We do not have to be positively biased to have access to certain roadshows or financial data. If we feel that the situation is bearish, we say so in complete independence.
12/ Loss aversion bias and disposition effect
The disposition effect is an anomaly discovered in behavioural finance. It relates to the tendency of investors to sell assets that have increased in value, while keeping assets that have dropped in value. The fear of realizing a loss can cripple investors, prompting them to hold onto a losing investment long after it should have been sold or to offload winning stocks too soon.
Thanks to our 'Trend Analysis' widget, you benefit from an emotion-free trading plan. Here too, if we think that a stock market situation is bearish, we say so with the same hindsight as if it were bullish.
Example:
Disclaimer
The views expressed on this blog are my own and do not necessarily reflect the views of my employer.
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