Behavioural Finance: To exploit behavioural biases focus on the folly of the many, not the few

written by Peter Sainsbury

“The fault, dear investor, is not in our stars — and not in our stocks — but in ourselves…”
Ben Graham

One of the greatest sources of edge is the one and only thing you have any power over – your own behaviour. If you can keep your head, while everyone else is losing theirs, then you can be there to exploit the mistakes of others and scoop up what is being left on the table.

Behavioural biases are the most persistent source of advantage in both financial and betting markets. Yet they are the most difficult to exploit. These biases have always been present and always will; human nature doesn’t change after all. We may think that we have evolved into smart people, capable of coldly calculating the odds of an event occurring and betting when the odds are in our favour. Unfortunately, our brains are still running with the same software that our ancestors had, thousands of years ago.

Behavioural finance can be thought of as including two different types of bias: emotional and cognitive. Emotional biases are where our feelings (hopes, fears, desires, etc.) distort our ability to make decisions rationally. Cognitive biases on the other hand are types of thinking that occur when we’re processing information. They are the mental shortcuts that quickly help us make sense of the world and make decisions. In this article I look at some of the most common biases to affect participants in both betting and financial markets, and what you can do to exploit them when they appear in others.

This presents an opportunity for the investor with sufficient foresight to anticipate what the next up and coming alternative asset is likely to be. Institutional investors tend to wait before an alternative asset becomes investable. But that means the greatest value opportunities lie in being ahead of the curve and then being able to benefit from the surge in institutional interest. Once institutional investor involvement in an asset becomes mainstream the returns may start to disappoint.

Emotional Biases, Which are the main ones?

“Though business conditions may change, corporations and securities may change and financial institutions and regulations may change, human nature remains essentially the same. Thus the important and difficult part of sound investment, which hinges upon the investor’s own temperament and attitude, is not much affected by the passing years.”
Ben Graham

1. Loss Aversion

People typically overcompensate to avoid taking a loss. Research suggests that people typically feel the pain of a loss twice as much as an equivalent win.

The impact this has is that bettors tend to hold onto losing bets longer than they should. Instead of laying off the bet or trying to hedge their position they ride it out rather than realise a loss. On the flipside this bias can also see people take a win too early.

The bookies know this. The ability to ‘cash out’ of a bet seems like a great feature and used carefully it can be. But most of the time it will be those who are in the money (the odds have shortened since they placed their bet) that are most likely to cash out.

2. Endowment effect

The endowment effect is where market participants place a disproportionately high value on those investments or bets they have already made. An example might be a homeowner that sets an unrealistically high asking price for their property. After all they lived there for decades, loved, and cared for it. It must be worth more! A similar thing happens in betting and investment where you hold onto a position for too long, not willing to consider that you are emotionally attached to it.

The result is that capital and emotion are tied up and you are unable to exploit better opportunities elsewhere.

3. Status quo bias

People are generally comfortable where they are now. Rather than adapting to changing circumstances or desires they plod on with whatever they are doing, how it’s always been done. In doing so they miss opportunities that they could benefit from. For an investor or bettor suffering from status quo bias this might mean that they stick to a certain investment or sports market even though there are better opportunities for profit elsewhere.

This bias occurs because people are typically very resistant to change. Worried that they will have to face lots of decisions and fearful of high transaction costs they keep things as they are. Other biases play a part. Loss aversion and the endowment effect mean they are afraid of taking losses on current investments and because they place too high a value on them, exiting the trade becomes drawn out.

One example of regret aversion is career risk. Instead of professional investors pursuing contrarian positions they stick to the herd. Economist John Maynard Keynes said it best, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

4. Regret aversion

The pain of regret from a poor investment decision is very powerful. It can be the fear of missing out on a market that goes up or a sports event that they didn’t bet on that ultimately won. It can also be the regret that comes from having a losing position, “I knew it was going to lose, why was I so stupid to place a bet?”

Regret aversion can result in herd-like behaviour. For example, investors piling their funds into the latest bankrupt stock to go up 400%, easing the regret that they didn’t own it earlier and the perceived regret they will feel if it goes up another 400%. It can also work the other way too. The pain of past mistakes can linger for years; people may avoid betting on certain markets to avoid the pain of regret.

5. Overconfidence

“The illusion that we understand the past fosters overconfidence in our ability to predict the future.”
Daniel Kahneman

According to investment strategist Michael Mauboussin there are three forms of overconfidence: overestimation, over-placement, and over-precision. Overestimation means you are overconfident in your abilities. Over-placement relates to the confidence that you are better than those around you. Finally, over-precision is when you become overconfident when answering questions that are difficult.

One of the risks that we face in the information age is that even if the amount of information is increasing, the gap between what we know and what we think we know is widening still further. As Dan Gardner suggests in his book Future Babble, “In fact, more information makes more explanations possible, so having lots of data available can actually empower our tendency to see things that aren’t there.”

In one study eight experienced bookmakers were shown a list of 88 variables found on a typical past performance chart on a horse – the weight to be carried, the number of races won, the performance in different conditions, etc. The bookmakers were then given data for the past 40 races and were asked to rank the top five horses in each race four times, each time using more and more information.

Accuracy was pretty much unchanged regardless of the amount of information the bookmakers had at their disposal. However, what happened to the bookmakers’ confidence? It soared as the information set increased. With five pieces of information, accuracy and confidence were quite closely related. However, by the time 40 pieces of information were being used, accuracy was still exactly the same, but confidence soared from below 20% to almost 35%!

Yet more information doesn’t necessarily mean you have an edge, it just creates greater confidence. The result of this is that bettors and investors become emboldened, firm in the belief that they understand cause and effect. This can result in what is known as the Green Lumber Fallacy, whereby the narrative that investors and bettors hold dear doesn’t match the real world. Over-confidence and a misunderstanding of reality then leads to excessive amounts of unprofitable betting and trading.

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Cognitive Biases, Which are the main ones?

“We can be blind to the obvious, and we are also blind to our blindness.”
Daniel Kahneman

1. Framing effect

Framing reflects the way information or opinion is presented. This framing can cause people to make different decisions versus those based on the facts alone. In the book Thinking, Fast And Slow the authors give the example of a choice between two bets that were tested on subjects in an experiment:Framing reflects the way information or opinion is presented. This framing can cause people to make different decisions versus those based on the facts alone. In the book Thinking, Fast And Slow the authors give the example of a choice between two bets that were tested on subjects in an experiment:

  • Would you accept a gamble that offers a 10% chance to win $95 and a 90% chance to lose $5?
  • Would you pay $5 to participate in a lottery that offers a 10% chance to win $100 and a 90% chance to win nothing?

The outcome of both bets is that you either lose $5, or you win $95. However, the experiment revealed that the second bet attracted much more interest. As the authors describe, “A bad outcome is much more acceptable if it is framed as the cost of a lottery ticket that did not win than if it is simply described as losing a gamble.”

2. Availability bias

When we make decisions, we tend to be swayed by what we remember. What we remember is influenced by many things including beliefs, expectations, emotions, and feelings as well as things like the frequency of exposure. The availability bias as it is known can substantially and unconsciously influence our judgment. We too easily assume that our recollections are representative and true and discount events that are outside of our immediate memory.

Behavioural psychologist Daniel Kahneman writes: “People tend to assess the relative importance of issues by the ease with which they are retrieved from memory—and this is largely determined by the extent of coverage in the media.”

3. Mental accounting

People tend to act as if there is a bucket of cash designated for different activities: one for living expenses, one for retirement, another as their betting bank roll, and so on. The divisions might not stop there; within a betting bank roll someone might arbitrarily divide it between high and low risk bets.

Money is inherently fungible. It doesn’t matter if one bucket is up $1,000 if two others are both down $750 each. You are still down $500 overall. Yet that’s not how people behave.

4. Anchoring or recency bias

“In a few months, I expect to see the stock market much higher than today.”
Irving Fisher

These were the words of America’s distinguished and famous economist and professor of economics at Yale University 14 days before Wall Street crash on Black Tuesday, 29th October 1929. Only days later, the Harvard Economic Society offered this analysis to its subscribers: “A severe depression such as 1920–21 is outside the range of probability. We are not facing a protracted liquidation.”

Most investors and bettors anticipate a future quite much like the recent past. One reason is that things generally continue as they have been, and so major changes just don’t occur very often. Another reason is that most people don’t do “zero-based” forecasting. Instead they start with the current observation or normal range and then add or subtract a bit as they think is appropriate. A final reason is that real “sea changes” are extremely difficult to foretell.

5. Confirmation bias

“The more you believe something to be true, the more you will have accumulated evidence to support it.”
Van Tharp

Another danger is confirmation bias. We seek out information that confirms our own worldview and reject or ignore any disconfirming evidence. According to Eli Pariser, author of the book Filter Bubbles: “The filter bubble tends to dramatically amplify confirmation bias—in a way, it’s designed to. Consuming information that conforms to our ideas of the world is easy and pleasurable; consuming information that challenges us to think in new ways or question our assumptions is frustrating and difficult…A world constructed from the familiar is the world in which there’s nothing to learn.”

As you and I become more connected to more and more people, it also becomes more likely that we’ll bump into people that disagree with us. In theory confirmation bias should become less of an issue, but what happens instead is that people double down on their own perspective, defending it to the hilt. According to media and technology analyst Benedict Evans, “The more the Internet exposes people to new points of view, the angrier people get that different views exist.”

Yet as bettors, updating our views effectively is crucial in making sure that our beliefs accurately reflect reality.

When are biases ripe for exploitation?

“The key to successful contrarian investing is to focus on the folly of the many, not the few.””
Michael Mauboussin

While individuals can be irrational, markets tend not to be. Markets aggregate all the individual errors of judgement (whether that’s analytical, informational, or behavioural) to form a reasonably accurate collective judgement of the price.

Tempting as it is to observe the behaviour of one person or groups apparently irrational behaviour (e.g. young day traders ploughing into bankrupt stocks), you cannot extrapolate individual behaviour to that of the market. While the irrational, over-confident buyer might get all the frontpage news coverage, there could be an equally irrational, over-confident seller on the other side of the trade.

Critical to understanding and taking advantage of market biases is understanding a) how the beliefs of market participants develop, b) how and when those beliefs become correlated - pushing prices away from value - and finally c) when the market moves from being wise to mad and back to wise again.

How beliefs develop

According to Malcolm Gladwell, author of The Tipping Point it is important to have the right people for a belief to develop and spread. First, connectors are people that know a lot of people and have a special gift for bringing the world together. Second, mavens are information specialists, and have the knowledge and the social skills to start word of mouth epidemics. The final group of people that are required to turn a belief into an epidemic is the salesperson. Salespersons have the charisma to persuade you that a story is worth paying attention.

A sticky story is also an important factor behind the development and spread of beliefs. For it to go viral a contagious element is required. This is very difficult to know in advance, but by examining what worked for conspiracy theories and proverbs we can begin to see the tale-tale signs. According to Chip and Dan Heath, authors of Made To Stick: Why Some Ideas Survive and Others Die there are 6 principles in order for a belief to take hold: it needs to be simple, unexpected (generating interest and curiosity), concrete, credible, emotional and finally it has to be a compelling story.

The final factor behind the transmission of beliefs is the power of the right context. If we hear something that resonates with us on a personal level, particularly when it’s connected with the emotion of fear then it weighs more heavily in our minds.

The strength and speed with which beliefs spreads depends upon the ’majority illusion’. When people believe that a majority of their network think a certain way - whether that perception is correct or not - they are more likely to act on it. Humans are inherently social animals and so have a desire to conform to the crowd’s beliefs. The right people, a sticky story and the right context and beliefs can be transmitted rapidly, just like a contagious epidemic.

Overextrapolation

According to Peter Atwater beliefs which are “over-believed” by investors, those are easily extrapolated into the future are the most dangerous for market participants, “When everyone believes something is going higher, like interest rates last fall, the opposite is likely. As I write often, extrapolation kills. And the bigger the trend-extrapolating headline and the more prominent the headline’s position, the more likely a reversal is. Typically, when something makes it to front page coverage, the end is near.”

Market participants can take things too far though, believing that recent trends are likely to continue, well into the future. This can be seen in sports markets when one player or team performs constantly well. Sports commentators, journalists, and bettors believe and promote the story as to why they are performing so well.

Financial and betting markets also have some unique properties that explain why beliefs can spread so quickly, but also why they can break down. The price. The beliefs of investors and bettors impact the price, but the price also impacts on beliefs. A rise in an assets value or a shortening in the odds embolden those that have bet on this outcome that they have made a good decision.

Diversity often breaks down when beliefs (often also reflected in prices) become too stretched. Seasoned investors might take a back seat while novices push prices to more extreme levels. When this happens, there is no countervailing force to cancel out the irrationality of one individual or group.

Sentiment

Magazine front covers also have a long history of proclaiming erroneous predictions at critical turning points in both economic activity and the markets. Far from being prescient, instead they tend to extrapolate current trends. Two of the most infamous come from The Economist and Business Week.

In March 1999 The Economist proclaimed the beginning of a new era of low oil prices with the cover “Drowning in oil”. Meanwhile, two decades earlier Business Week ran a cover story highlighting how high inflation is destroying the stock market. The cover title read, “The Death of Equities.” In both cases the magazines trend extrapolation came to an abrupt halt and went into reverse. It was a good time to buy oil in 1999 and a good time to buy equities in 1979.

In the same way that headlines tell us what we believe to be true, magazine covers and feature articles are often scheduled weeks or months in advance. For this to happen the trend has to have been in place for some time. The magazine cover can often be one step too far and so provide a contrarian signal to investors.

Equally, watch out for headlines reporting that the performance of a company or sports team is “unstoppable”, “no end in sight” or “steamrolling the competition”. When that occurs, it can often signal a reversal in sentiment is imminent.

The wisdom (and madness) of crowds

When returns have been good in a particular market for some time, traders and investors begin to imitate each other. Similarly, bettors may start to employ or copy the strategies used by tipsters or other prominent sports traders. When this happens the diversity of the market declines, pushing prices further away from their fundamental value.

This crowding also creates fragility. The performance of the strategy or asset obscures the fact that you are having to take greater amounts of risk for it to payoff. Meanwhile, it also results in less liquidity and so any shock result means prices must rebound sharply in the other direction to clear the market.

You need to watch out for the moment when the crowd slips from wisdom to madness. It is only when the beliefs of investors correlate with one another and push prices away from fundamental value that behavioural inefficiencies provide opportunities.

Emotional and Cognitive Biases, How to take advantage of them in trading and betting?

  • Be mindful of sentiment and overextrapolation: Most of the time markets are reasonably priced. This is a time to keep your powder dry and not be too hasty. Markets are also prone to extremes. When sentiment is uniformly positive or negative, be prepared (emotionally and financially) to visit the opposite side of the argument. But remember, being a contrarian for the sake of being a contrarian is a bad idea, and the consensus can often be correct.
  • Focus on value: When sentiment shifts are excessive, expectations become unduly high or low. Figure out what must be believed to justify the prevailing price and compare that to plausible scenarios. Other investors may have too much career risk and be very wary of having a punt on unpopular, highly contrarian bets. This is an advantage for the private investor or bettor. We don’t have to worry about what others think.
  • Lean on facts, rather than opinion: When a market is subject to extreme sentiment, ensure to explicitly separate facts from opinions. A fact is information that is presumed to have objective reality and therefore can be disproved. An opinion is a belief that is more than an impression but does not meet the standard of positive knowledge. Both facts and opinions are useful for investors, but facts should always rule.
  • Time your entry carefully: Behavioural inefficiencies can operate over different time frames. Taking advantage of behavioural inefficiencies can take more time than you realise for the market to correct itself. Be prepared for the consensus to be proved right, eventually.
  • Have the courage of your convictions: Investment legend Ben Graham summed it up well when he said, “Have the courage of your knowledge and experience. If you have formed a conclusion from the facts and if you know your judgment is sound, act on it—even though others may hesitate or differ. You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”

Behavioural biases are the most persistent source of advantage in both financial and betting markets. Yet they are the most difficult to exploit. The lesson from this article is that if you want to be there to exploit those biases then you need to focus on the folly of the many, not the few. For while individuals are often irrational, well-functioning markets tend not to be. Be patient though and watch out for the signs for when beliefs go unquestioned, and prices lose track of reality.

Peter Sainsbury

Peter Sainsbury

Peter Sainsbury is the author of The Winning Formula: Betting on F1, Commodities: 50 Things You Really Need To Know and a number of other books. At Material Risk he details his observations from the world of commodity markets, economics, and investing.

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