Any experienced trader knows that psychology plays a major role in the stock market. Human beings may have the most developed brains of any species on the planet, but our thought processes and judgments are far from perfect.
If you’ve ever wondered how market forecasters can consistently seem so certain of their projections even after they get them wrong over and over again, the “illusion of validity” is likely to blame.
“People are prone to experience much confidence in highly fallible judgment, a phenomenon that may be termed the illusion of validity,” Kahneman and Tversky wrote back in 1973.
ValueWalk recently discussed five cognitive biases that underlie the illusion of validity.
Overconfidence Bias
Most traders will admit that they aren’t 100 percent accurate with every call on every stock, every day. Where we get into trouble is estimating the likelihood that we are correct. Overconfidence bias is a well-established psychological phenomenon that states people tend to overestimate the likelihood of the outcome they personally see as most likely to happen, and underestimate the likelihood of the alternatives.
Confirmation Bias
While it would seem logical that investors should be dying to learn any information that could disrupt their investment theses, the exact opposite is typically the case. Confirmation bias is another psychological phenomenon in which people tend to seek out information that confirms what they already believe and avoid or ignore information that conflicts with those beliefs.
Representativeness Bias
Organization is great, but just because something shares one or a handful of traits with something else doesn’t mean the two things are identical or will behave identically. Traders know that stocks within a given sector are usually correlated. But, assuming that the stocks of Facebook Inc FB and Twitter Inc TWTR behave similarly because both companies are social media companies has been a pretty big mistake in recent years.
Anchoring Bias
First impressions are extremely important. People tend to assign more weight to the very first piece of information they learn about something than they do to subsequent information. This anchoring bias can quickly develop into stubbornness to change one’s mind about a stock or idea that happens to make a good first impression.
Hindsight Bias
We’ve all heard it a million times: Hindsight is 20/20. We all become…
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