Saturday, October 14, 2006

Logical fallacies: representativeness bias

Decision making is science in its own right. I have seen very few people who are good decision makers in one field and very poor in others. Many people fail to realize this. If their investing decisions go often wrong then they would probably infer that
1. They don’t have the correct information
2. They have the correct information but They don’t have required skills to derive correct inferences from that information.

Their comments on their failures give away their beliefs.. “If only I had the insider information I would have made money”…. “If I had done MBA in finance I would have been able to analyze the stock and made money”

More often than not, the reason of their failure can be attributed to failure in making rational decisions. It has nothing to do with finance. It has nothing to do with the amount of information they get. In coming few weeks I would explain the fallacies in reasoning which cause erroneous decisions.

Suppose I tell you that in last one year, every Monday morning I wrote a BUY or SELL in my diary for Sensex. In past one year 69.2% of my weekly BUY decisions were correct. Would you be interested in buying a weekly newsletter from me?

Interesting question. Think about it before you jump to a conclusion. As I’ve already hinted I’m questioning your capability to take rational decisions.


Before you send me the mail confirming you decision, I would like you to know the secret behind my correct predictions. I tossed the coin every Monday to decide whether the market will rise or fall.

Number of weeks I gave a BUY signal : 26
Number of weeks the Sensex closed higher than previous week: 36
Number of weeks I gave a BUY signal and Sensex rose : 18
% of weeks where my BUY signal was correct = 18/26 => 69.2%

Now you can infer that if you succeeded in 69.2% of all your BUY decisions this year, you haven’t done better than a Buffett’s orangutan in coin flipping contest. Similarly if an analyst brags about his “in the bull’s eye” recommendations he hasn’t done great job either. In Behavioral finance this is known as representativeness bias.



Gaurav Goel said...

Hey Friend,
I have been going through your blog and have been very impressed by it. I am new to investing in the indian market and was wondering if you knew any good stock screens that I could use to screen indian stocks? I don't seem to find any good ones.



Interesing post on logical bias.