May 18, 2009|
Watch what you commit to
In the previous article on 'loss aversion' ,we discussed how losses have a much larger impact than corresponding gains on analysts and investors. In this article, we shall examine another tendency called 'commitment bias'.
What is 'commitment bias'?
We all have a strong desire to be (and to appear) consistent with our past actions. Once we make a choice, we face personal and social pressures to behave in line with that commitment. The reason for this tendency is easy to understand. Human evolution happened predominantly in conditions of scarcity. It was important that people behaved in a consistent manner for the efficient use of resources at both an individual as well as at a societal level. Reliable behavior was critical for the survival of our early ancestors.
However, the commitment bias can lead to irrational behavior if decisions are not revised even when facts indicate that they should be. As the noted economist, John Maynard Keynes reportedly said, "When the facts change, I change my mind. What do you do, sir?" This irrationality plays a big role in a variety of decisions, including investing in stocks.
- Betting: Psychologists studying people at a racetrack found that just after placing a bet, bettors are far more confident of their horse's chances of winning than they were immediately before placing the bet. Just the act of placing the bet changes their thinking.
- Prisoners of War: At the time of the Korean War, some US prisoners of war (POWs) defect to China. The Chinese worked on the POWs by extracting harmless admissions in writing out of them and building upon it. The POWs found it very hard to go back upon what they had themselves written down.
- Political ideologies: Politicians, around the world, often end up having very rigid opinions. There are often intelligent and well meaning people in politics. But the nature of their job requires taking public stances. Over time, it becomes very hard for them to accommodate the opposing view.
Avoiding the commitment bias in stock picking
- Admit: The first step in dealing with biases is to admit their presence.
- Keep your opinions private: One of the great pitfalls of speaking/writing publicly about one's opinions is that commitment bias kicks in. It is much better to keep your investment views to yourself. That way you can change your view if there is a change in the facts or your reasoning. Individual investors have a natural advantage over institutional investors and analysts who need to broadcast their opinions by the very nature of their job.
- Stress on your reasoning: If you have to make public statements, you should stress on your reasoning and not on your conclusions. That way, you're unlikely to be inflexible about your conclusions even when the facts change or the reasoning needs to be modified. You should also constantly question your reasoning in order to become a rational investor.
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