Ambiguity effect

The ambiguity effect is a cognitive bias where decision making is affected by a

lack of information, or "ambiguity". The effect implies that people tend to select
options for which the probability of a favorable outcome is known, over an option
for which the probability of a favorable outcome is unknown. The effect was first
described by Daniel Ellsberg in 1961.
Example
A more realistic example might be the way people invest money. A risk-averse
investor might tend to put their money into "safe" investments such as
government bonds and bank deposits, as opposed to more volatile investments
such as stocks and funds. Even though the stock market is likely to provide a
significantly higher return over time, the investor might prefer the "safe"
investment in which the return is known, instead of the less predictable stock
market in which the return is not known. The ambiguity effect is a possible
explanation why people are reluctant to adopt new practices in the work place.
It is human to avoid ambiguous knowledge - to assume things are knowable when
they are not. This is related to the clustering illusion. When presented with large
amounts of confounding variables, people still tend to claim knowledge of the
unknowable. This produces cognitive dissonance which when avoided leads
people to try to change venues to something with more certainty.
Another example for the ambiguity effect could be the
following one: I know that there is at best a moderate chance
of my winning a local singing competition as the local singers
are good. There is a competition in the next town but I do not
know how good the singers are there. Rather than” risk it” I just
enter for the local competition.
The simplest demonstration of this effect involves two boxes: one contains 50 red
balls and 50 green balls, whereas the second contains 100 red and green balls in
unknown proportion. You draw a ball blindly from a box and guess its color. If
your guess is correct, you win $20; otherwise you get nothing. On which box
would you rather bet? Ellsberg argued that people prefer to bet on the 50/50 box
rather than on the box with the unknown composition, even though they have no
color preferences and so are indifferent between betting on red or on green in
either box..

Avoid
Investors need to be educated on how the relevant asset classes
perform and how adding these asset classes to a diversified portfolio
can be a beneficial action. Clients who only invest in certain familiar
indexes because they do not feel they can predict the probable payoffs
of investing elsewhere may likewise benefit from more information
about the benefits of other options. In short, education is the key to
overcoming ambiguity aversion.
The key advice that can be offered is to not let competence in a certain
area prevent investments in other areas as well. For example, if you
have an investor who is an expert in real estate, does that mean that he
or she should be 100 percent invested in real estate? The obvious
answer is no. Stick to the fundamentals of a balanced, well-diversified
portfolio.

Optimistic

Optimism bias (also known as unrealistic or comparative optimism) is

a cognitive bias that causes a person to believe that they are at a lesser
risk of experiencing a negative event compared to others.
Four factors exist that cause a person to be optimistically biased: their
desired end state, their cognitive mechanisms, the information they
have about themselves versus others, and overall mood. Most people
have heard of “rose-colored glasses” and know that those who wear
them tend to view the world with undue optimism. Empirical studies
referred to in previous chapters demonstrate that, with respect to
almost any personal trait perceived as positive— driving ability, good
looks, sense of humor, physique, expected longevity, and so on—most
people tend to rate themselves as surpassing the population mean.
Explanation
Undue optimism can be financially harmful because it creates, for
investors, the illusion of some unique insight or upper hand. Often,
people on some level believe that they can “see” inaccurately priced
securities, when in fact they cannot. It is devoted to exploring some of
the behaviors related to optimism that can cause investment mistakes.
First, many investors falsely believe themselves to be above-average
investors. Finally, some thought leaders in the investment industry
continuously warn investors about the lack of “real returns” that
investors actually attain. People, of course, do not perceive their own
situations this way—they often think that they are obtaining good real
returns.
Examples
 For example, we may underestimate our risk of being in a car accident.
Investors, too, tend to be overly optimistic about the markets, the
economy, and the potential for positive performance of the
investments they make. Many overly optimistic investors believe that
bad investments will not happen to them—they will only afflict
“others.” Such oversights can damage portfolios because people fail to
mindfully acknowledge the potential for adverse consequences in the
investment decisions they make.

Avoid
In studies that involved attempts to reduce the optimism bias through actions
such as educating participants about risk factors, encouraging volunteers to
consider high-risk examples, and educating subjects and why they were at risk,
researchers have found that these attempts led to little change and in some
instances increased the optimism bias. For example, telling someone the risks of
dying from a habit such as smoking can make them more likely to believe that
they will not be negatively affected by the behavior.
“Live below your means, and save regularly
“Asset allocation is the key to a successful portfolio
“Encourage the use of a financial advisor.”

Gambler Fallacy
• When it comes to probability, a lack of understanding can lead to incorrect
assumptions and predictions about the onset of events. One of these
incorrect assumptions is called the gambler's fallacy.
• In the gambler's fallacy, an individual erroneously believes that the onset of
a certain random event is less likely to happen following an event or a
series of events. This line of thinking is incorrect because past events do not
change the probability that certain events will occur in the future.
• For example, consider a series of 20-coin flips that have all landed with the
"heads" side up. Under the gambler's fallacy, a person might predict that
the next coin flip is more likely to land with the "tails" side up.
• This line of thinking represents an inaccurate understanding of probability
because the likelihood of a fair coin turning up heads is always 50%. Each
coin flip is an independent event, which means that any and all previous
flips have no bearing on future flips.
Example
• Conversely, other investors might hold on to a stock that has fallen in
multiple sessions because they view further declines as "improbable". Just
because a stock has gone up on six consecutive trading sessions does not
mean that it is less likely to go up on during the next session.
Avoiding Gambler's Fallacy
• It's important to understand that in the case of independent events, the
odds of any specific outcome happening on the next chance remains the
same regardless of what preceded it.
 • With the amount of noise inherent in the stock market, the same logic
applies: Buying a stock because you believe that the prolonged trend is
likely to reverse at any second is irrational.
• Investors should instead base their decisions on fundamental and/or
technical analysis before determining what will happen to a trend.
Herd Behavior
people believe to be a hardwired human attribute: herd behavior, which is the
tendency for individuals to mimic the actions (rational or irrational) of a larger
group.
• Individually, however, most people would not necessarily make the same
choice.
• The second reason is the common rationale that it's unlikely that such a
large group could be wrong. After all, even if you are convinced that a
particular idea or course or action is irrational or incorrect, you might still
follow the herd, believing they know something that you don't.
The Dotcom Herd:
• Herd behavior was exhibited in the late 1990s as venture capitalists and
private investors were frantically investing huge amounts of money into
internet-related companies, even though most of these dotcoms did not (at
the time) have financially sound business models.
For example, if a herd investor hears that internet stocks are the best investments
right now, he will free up his investment capital and then dump it on internet
stocks.
Furthermore, it's extremely difficult to time trades correctly to ensure that you
are entering your position right when the trend is starting. By the time a herd
investor knows about the newest trend, most other investors have already taken
advantage of this news, and the strategy's wealth-maximizing potential has
probably already peaked
Avoiding the Herd Mentality:
• While it's tempting to follow the newest investment trends, an investor is
generally better off steering clear of the herd.
 • Just because everyone is jumping on a certain investment "bandwagon"
doesn't necessarily mean the strategy is correct. Therefore, the soundest
advice is to always do your homework before following any trend.
Just remember that particular investments favored by the herd can easily become
overvalued because the investment's high values are usually based on optimism
and not on the underlying fundamentals.
Disposition Effect
• The disposition effect is an anomaly discovered in behavioral finance. It relates to the tendency
of investors to sell shares whose price has increased, while keeping assets that have dropped in
value.
• Hersh Shefrin and Meir Statman identified and named the effect in their 1985 study, which
found that people dislike losing significantly more than they enjoy winning. The disposition
effect has been described as "[o]ne of the most robust facts about the trading of individual
investors" because investors will hold stocks that have lost value yet sell stocks that have gained
value.
• In 1979, Daniel Kahneman and Amos Tversky traced the cause of the disposition effect to the so-
called "prospect theory". The prospect theory proposes that when an individual is presented
with two equal choices, one having possible gains and the other with possible losses, the
individual is more likely to opt for the former choice even though both would yield the same
economic result.
 disposition effect is not a rational sort of conduct because of the reality of stock
market momentum, meaning “that stocks that have done well over the past six months tend to keep
doing well over the next six months; and that stocks that have done poorly over the past six months
tend to keep doing poorly over the next six months.” This being the case, the rational act would be
“to hold on to stocks that have recently risen in value; and to sell stocks that have recently fallen in
value. But individual investors tend to do exactly the opposite.

Avoiding the disposition effect

The disposition effect can be minimized by means of a mental approach called "hedonic framing". For
example, individuals can try to force themselves to think of a single large gain as a number of smaller
gains, to think of a number of smaller losses as a single large loss, to think of the combination of a major
gain and a minor loss as a net minor gain, and, in the case of a combined major loss and minor gain, to
think of the two separately.[6]

Regret
Regret theory states that people anticipate regret if they make a wrong choice
and they take this anticipation into consideration when making decisions. Fear of
regret can play a significant role in dissuading someone from taking an action or
motivating a person to take an action.
When investing, regret theory can either make investors risk averse or it can
motivate them to take greater risks. For example, suppose that an investor buys
stock in a small growth company based only on a friend's personal
recommendation. After six months, the stock falls to 50% of the purchase price,
so the investor sells the stock and realizes a loss. To avoid this regret in the future,
the investor will ask questions and research any stocks that his friend
recommends.

Conversely, suppose the investor didn't take the friend's recommendation to buy

the stock, and the price increased by 50%. To avoid the regret of missing out, the
investor will be less risk averse and will likely buy any stocks that his friend
recommends in the future without conducting any background research of his
own.

Suppose that regret-averse Jim is now considering two investments, both with
equal projected risk and return. One stock belongs to Large Company, Inc., while
the other confers a share in Medium-Size Company, Inc. Even though,
mathematically, the expected payoffs of investing in these two companies are
identical, Jim will probably feel more comfortable with Large Company. If an
investment in Large Company, Inc., fails to pay off, Jim can rationalize that his
decision making could not have been too egregiously flawed, because Large
Company, Inc., must have had lots of savvy investors. Jim doesn’t feel uniquely
foolish, and so the culpability component of Jim’s regret is reduced. Jim can’t rely
on the same excuse, however, if an investment in Medium-Size Company fails.
Instead of exonerating himself (“Lots of high-profile people made the same
mistake that I did—perhaps some market anomaly is at fault?”), Jim may
condemn himself (“Why did I do that? I shouldn’t have invested in Medium-Size.
Only small-time players invested in Medium-Size, Inc. I feel stupid!”), adding to his
feelings of regret. It’s important to recall here that Large Company and Medium-
Size Company stocks were, objectively, equally risky.

Avoid

Investing Too Conservatively. No matter how many times an investor has been
“burned” by an ultimately unprofitable investment, risk (in the context of proper
diversification) is still a healthy ingredient in any portfolio.
Staying Out of the Market after a Loss. There is no principle more fundamental in
securities trading than “buy low, sell high.” Nonetheless, many investors’ behavior
completely ignores this directive.

Holding Losing Positions Too Long. An adage on Wall Street is, “The first loss is the
best loss.” While realizing losses is never enjoyable, the wisdom here is that
following an unprofitable decision, it is best to cut those losses and move on.

Media Response

• Study of the effects of news on investment decisions:

– Two groups: one received news and one did not
– The group with no news outperformed
the group that received news
• People often feel the need to react to new information
• News is often irrelevant to long-term performance and is often
misinterpreted

Information overload can cause stress

• Advice:
– Stick with a long-term investment strategy
– Turn your televisions off when it comes to investment news
– Don’t feel you need to react to every bit
of information you hear