Meeting Investors' Goals
Your friend (or client) comes to you with a list of companies they believe are worth adding to their portfolio. However, you notice something about this list: you have seen almost all of these company names in your favorite local financial media in the recent past.
What are the two cognitive biases your friend (or client) appears to be affected by?
What is the definition of each of these two biases?
What are the three pieces of advice you would give your friend (or client) to avoid these two biases?
Every year, the U.S. Army must select from an applicant pool in the hundreds of thousands to meet annual enlistment targets, currently numbering in the tens of thousands of new soldiers. A critical component of the selection process for enlisted service members is the formal assessments administered to applicants to determine their performance potential. Attrition for the U.S. military is hugely expensive. Every recruit that does not make it through basic training or beyond a first enlistment costs hundreds of thousands of dollars. Academic and other professional settings suffer similar losses when the wrong individuals are accepted into the wrong schools and programs or jobs and companies. Picking the right people from the start is becoming increasingly important in today's economy and in response to the growing numbers of applicants. Beyond cognitive tests of ability, what other attributes should selectors be considering to know whether an individual has the talent and the capability to perform as well as the mental and psychological drive to succeed? Measuring Human Capabilities: An Agenda for Basic Research on the Assessment of Individual and Group Performance Potential for Military Accession examines promising emerging theoretical, technological, and statistical advances that could provide scientifically valid new approaches and measurement capabilities to assess human capability. This report considers the basic research necessary to maximize the efficiency, accuracy, and effective use of human capability measures in the military's selection and initial occupational assignment process. The research recommendations of Measuring Human Capabilities will identify ways to supplement the Army's enlisted soldier accession system with additional predictors of individual and collective performance. Although the primary audience for this report is the U.S. military, this book will be of interest to researchers of psychometrics, personnel selection and testing, team dynamics, cognitive ability, and measurement methods and technologies. Professionals interested in of the foundational science behind academic testing, job selection, and human resources management will also find this report of interest.
After having followed your advice, your friend (or client) calls you to arrange a meeting to discuss new investment opportunities. They tell you that they have made forecasts on the expected returns of each of those investment opportunities. On your way to the meeting, you can't help imagining what cognitive biases may have affected your friend (or client) when doing their forecasts of expected returns.
Give two cognitive biases that may have affected your friend (or client) when doing their forecasts of expected returns.
Write down two realistic scenarios (one for each bias) that may have happened to your friend (or client) and which illustrates each of the two biases.
The Confirmation Bias Three multi-ethnic senior men sitting on bench talking kali9 / Getty Images The confirmation bias is based on finding that people tend to listen more often to information that confirms the beliefs they already have. Through this bias, people tend to favor information that confirms their previously held beliefs. This bias can be particularly evident when it comes to issues like gun control and global warming. Instead of listening to the opposing side and considering all of the facts in a logical and rational manner, people tend simply to look for things that reinforce what they already think is true. In many cases, people on two sides of an issue can listen to the same story, and each will walk away with a different interpretation that they feel validates their existing point of view. This is often indicative that the confirmation bias is working to "bias" their opinions. The Hindsight Bias Rearview mirror Earl Richardson / EyeEm / Getty Images The hindsight bias is a common cognitive bias that involved the tendency of people to see events, even random ones, as more predictable than they are. In one classic psychology experiment, college students were asked to predict whether they thought then-nominee Clarence Thomas would be confirmed to the U.S. Supreme Court. Prior to the Senate vote, 58% of the students thought Thomas would be confirmed. The students were polled again following Thomas's confirmation, and a whopping 78% of students said they had believed Thomas would be confirmed. This tendency to look back on events and believe that we “knew it all along” is surprisingly prevalent. Following exams, students often look back on questions and think “Of course! I knew that!” even though they missed it the first time around. Investors look back and believe that they could have predicted which tech companies would become dominant forces. The hindsight bias occurs for a combination of reasons, including our ability to "misremember" previous predictions, our tendency to view events as inevitable, and our tendency to believe we could have foreseen certain events.
Time has come for your friend (or client) to rebalance their portfolio. You warn them of the "endowment" effect. They tell you that this effect is silly; it would never happen to them.
According to you friend's (or client's) original strategy, the rebalancing of their portfolio implies selling 100 shares of company XYZ and buying 100 shares of company ABC. Companies XYZ and ABC are privately held (i.e. their share price cannot be observed on a stock exchange)
Knowing that XYZ and ABC are extremely similar companies in every aspect, how would you show to your friend (or client) that the "endowment" effect is not so silly after all?
No problem
Now that you have exposed many of their cognitive biases to them, your friend (or client) is slightly upset and accuses you of being pretentious for pointing out other people's cognitive biases but remaining silent about your own.
To calm them down, give one cognitive bias that you haven't yet mentioned in this assignment and which may affect you.
(If you feel that none of the remaining cognitive biases may affect you, please choose one nonetheless.)
To further convince your friend (or client), write down an anecdote when you were affected by your chosen cognitive bias. If you do not have such an anecdote, make one up!
Though the concept of illusory superiority arguably dates back to Confucius and Socrates, it may come as a shock that its discussion in the form of the Dunning- Kruger Effect is almost 20 years old; and though it may simply be a result of an echo chamber created through my own social media, it seems to be popping up quite frequently in the news and posts that I’ve been reading lately – even through memes! For those of you unfamiliar with the phenomenon, the Dunning-Kruger Effect refers to a cognitive bias in which individuals with a low level of knowledge in a particular subject mistakenly assess their knowledge or ability as greater than it is. Similarly, it also refers to experts underestimating their own level of knowledge or ability. But, then again, maybe it’s not my echo chamber… maybe it is part and parcel of our new knowledge economy (Dwyer, 2017; Dwyer, Hogan & Stewart, 2014) and the manner in which we quickly and effortlessly process information (right or wrong) with the help of the internet. In any case, given the frequency with which I seem to have encountered mention of this cognitive bias lately, coupled with the interest in my previous blog post 18 Common Logical Fallacies and Persuasion Techniques, I decided it might be interesting to compile a similar list – this time, one of cognitive biases. A cognitive bias refers to a ‘systematic error’ in the thinking process. Such biases are often connected to a heuristic, which is essentially a mental shortcut – heuristics allow one to make an inference without extensive deliberation and/or reflective judgment, given that they are essentially schemas for such solutions (West, Toplak, & Stanovich, 2008). Though there are many interesting heuristics out there, the following list deals exclusively with cognitive biases. Furthermore, these are not the only cognitive biases out there (e.g. there’s also the halo effect and the just world phenomenon); rather, they are 12 common biases that affect how we make everyday decisions, from my experience.]
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