The psychology of human misjudgment iii

The Psychology of

Human Misjudgment-

III

Bias # 4

Commitment &

Consistency

Rear Admiral

Husband E. Kimmel

In 1941 Admiral Kimmel was repeatedly warned about the possibility of war with Japan. On November 24, he was informed that a surprise attack could occur in any direction. However, Kimmel didn't think the United States was in any great danger, and since Hawaii was not specifically mentioned in the report, he took no precautions to protect Pearl Harbor.

“Destroy Most of

Your Secret Codes”

On December 3, he was told that American cryptographers decoded a Japanese message ordering their embassies around the world to destroy "most of your secret codes." Kimmel focused on the word "most" and thought that if Japan was going to war with the United States they would have ordered "all" their codes destroyed.

One hour before the attack on Pearl Harbor, a Japanese sub was sunk near the entry to the harbor. Instead of taking immediate action, Kimmel waited for confirmation that it was, in fact, a Japanese sub. As a result, sixty warships were anchored in the harbor, and planes were lined up wing to wing, when the attack came. The Pacific fleet was destroyed and Kimmel was court-martialed.

Scene from “The Fog of war”

Gulf of Tonkin Incident - Wikipedia, the free encyclopedia

http://en.wikipedia.org/wiki/Gulf_of_Tonkin_Incident#cite_note-5

You can and should see this documentary from:http://freedocumentaries.org/int.php?filmID=115

btw, The music is one of my favorite soundtracks.

This is commitment.

This is commitment

Warren Buffett once said “Chains of habit are too light to be felt until they are too heavy to be broken.”

A bad habit, once acquired, is very difficult to break because frequency (arising out of the consistency principle) makes it become more and more reinforced in your brain.

You need to develop the right mental habits early on in your life.

Inconsistent Behavior Can Cause Accidents

Generally speaking its good to be consistent with your past behavior and to be consistent with the role that you have been assigned.

When we wear masks we “play the part” too.

“Masks” is a good metaphor. I am waring the mask of a teacher here. I must “play the part”. I must not do anything inconsistent with what is expected of a teacher.

The idea of a mask is a very powerful idea. Think about the the idea in armed forces called “conduct unbecoming an officer.” When you are a senior army officer, even when you are not in uniform, you are not expected to indulge in “conduct unbecoming an officer.” The term is vague but it achieves what its meant to achieve so society is better off having these rules - rather these masks that we wear.

We wear many masks - I will take off the one I am wearing right now and will wear the one of a professional when i go to my office. Afterwards, I will be wearing one of a husband, a son, and a father. All our lives we wear these masks and do what is expected of us - we “play the part”

This conditions us to continue playing the part we have been assigned. And blindly doing so sometimes results in huge errors in cognition and behavior.

Cognitive Dissonance as the Engine Behind Self Justification

Fooling ourselves

How do Smokers Rationalize?

“The medical evidence is inconclusive”

“Other smart people do it so it can’t be all

that bad!”

“But I know a man who smoked three packs of cigarettes a day

and lived to be 99!”

The same old base rate fallacy again.

“It’s needed for my relaxation- I might have a shorter life but it

will be more enjoyable!”

Man is not a rational animal

He is a rationalizing one

Gamblers rationalize away their losses just to be able to maintain a belief in their gambling strategy. No wonder casinos love gamblers who “have a system.”

If you listen closely, you’ll find that gamblers tend to rewrite their history of successes and failures. All wins are due to skill, but all losses are due to bad (always temporary) luck.

Gamblers aren’t the only who fool themselves. All of us do it in some form or another.

We WANT to believe - and we go to ridiculous lengths to maintain our beliefs...

YouTube - Elton John - Believe 1995

http://www.youtube.com/watch?v=nM8VpC-F-k0

Status quo bias.

Examples:

Negative consent

Organ Donations

Brain Dead Investors

Sticky Dividends

Desire to be consistentWhy are dividends less volatile than earnings, and even less volatile than stock prices?

Confirmation Bias:Overweighing evidence

that confirms your prior notions and under

weighing evidence that contradicts it

We look for confirmation evidence all the time, and when we find it we GRASP it and give ourselves the “THUMBS UP”

Confirmation Bias: Overweighing evidence that confirms your prior notions and under weighing evidence that contradicts it

Its in the nature of things, that if you look hard enough for evidence that support your belief, you will find it. And that will intensify your belief...

“I will look at any additional evidence to confirm the opinion to which I have already come.”

Hugh Molson, British Politician

“What a man believes, he prefers to be true.” - Sir Francis Bacon

The Justification of Effort

Blood, tears, toil, and sweat - make us more determined i.e. more committed….

“If a person works hard to attain a goal, that goal will be more attractive

to the individual than it will be to someone who achieves the same goal

with little or no effort.” - Elliot Aronson in “The Social Animal

Sunk cost fallacy - I have too much invested in this situation to walk away nowI can’t afford to write this off.Maybe you can

Capital (mis)allocation decisionsTraditional Budgeting vs. Zero based budgeting

Why, during a hazardous

snowstorm, would we skip driving to a

concert if the tickets were free, but risk life and

limb to go if we had paid for the tickets?

- Richard THaler

The risk on the roads is the same, and we don't get the money back either way.

Lying through

your nose

Once you tell a public lie, you will have to keep on inventing more and more lies to be consistent with the first one.

If you take a public stand, and later find, you were wrong, you will find it hard to reverse your stand. After all, you don’t want to look foolish and fickle minded….

But having a flexible mind, which is subject to change based on new information which changes the odds is a PRECONDITION for success in science, in investment management, in all professions that that matter…

“If you Always Tell the truth you won’t have to remember your lies.”

- Mark Twain

Twain knew about the consistency principle, and what it makes us do.

There is a hindi saying which goes as follows “Ek Jhoot to bachaney ke liye hazaar jhoot bolney padte hain.” i.e. “to support one lie, you have to speak a thousand more…”

“George Bush was wrong in his claim that Saddam Hussein had WMD. He was wrong in claiming that Saddam was linked with the Al Qaeda. He was wrong in predicting that Iraqis would be dancing joyfully in the streets to receive the American soldiers. He was wrong in predicting that the conflict would be over quickly. He was wrong in estimating of the financial costs of the war...

“And he was famously wrong in his photo-op speech six weeks after the invasion began when he announced (under a banner reading “MISSION ACCOMPLISHED”) that “Major combat operations in Iraq have ended.”

“In 2006, with Iraq sliding into civil war and 16 American Intelligence Agencies having issued a report that the occupation of Iraq had increased Islamic radicalism and the risk of terrorism, Bush said: “I have never been more convinced that the decisions I made are the right decisions.””Carol Tavris & Elliot Aronson in “Mistakes Were Made (but Not by Me)”

While we laugh at Mr. Bush, we must acknowledge that the “functional equivalent” of Mr. Bush is there in all of us...

Growing Legs to Stand On

This is very nice metaphor used by Cialdini to illustrate who we invent new reasons to rationalize our prior decisions...

When Google announced last week that its video Web site YouTube would begin incorporating video ads, analysts calculated how much revenue the venture might bring in. And one analyst inadvertently revealed the fluid nature of assumptions underlying this kind of math.

See:Mary Meeker’s Fuzzy Math - The Numbers Guy - WSJ

http://blogs.wsj.com/numbersguy/mary-meekers-fuzzy-math-179/

Morgan Stanley analyst Mary Meeker initially projected that the YouTube ads would bring in $720 million next year. But there was one big problem with her calculation: She took the price of the ads, which was reported in several news articles as “$20 CPM,” to mean the price per ad impression, not per thousand ad impressions, which is what CPM means.

After Henry Blodget — the former stock analyst who, like Ms. Meeker, was a cheerleader for Internet stocks during the dot-com boom — called out the math mistake on Silicon Alley Insider, Ms. Meeker acknowledged the error.

Henry Blodget - Wikipedia, the free encyclopedia

http://en.wikipedia.org/wiki/Henry_Blodget

The Rehabilitation of Henry Blodget

http://www.fool.com/investing/small-cap/2004/11/24/the-rehabilitation-of-henry-blodget.aspx

Simply fixing the number would have reduced the projected revenue by a factor of 1,000, to a piddling $720,000, or about one-sixtieth of Google’s average revenue, per day, in the last quarter. But while Ms. Meeker was revisiting her calculation, she also revised other numbers used in her model. The revised report predicted between $75.6 million and $189 million in revenue for the video ads next year.

“In fixing the error, we also took the opportunity to dig deeper into our assumptions and … we provide an updated scenario analysis of the

opportunity … We apologize for any inconvenience this may have caused.”

In her initial report, Ms. Meeker assumed that 1% of YouTube’s estimated two billion monthly U.S. video streams would carry the ads. The second time around, that rose to 15% of YouTube’s 14 billion monthly world-wide streams, in one scenario she calculated, or 30% of 17.5 billion monthly streams in a more optimistic scenario. That change made up a good chunk of the projected revenue that would have been lost had she just fixed the CPM mistake.

The “functional equivalent” of Ms Meeker is there in all of us...

Endowment Effect

The Consequences of Ownership

Man mostly appraises himself and his possessions (things, spouse, friends, children) on the high side

Possessions are over-valued- once owned they suddenly become worth more to the owner than he would pay for them if he did not own them already – Endowment Effect

Man’s decisions are suddenly regarded by him as better than was the case just before he made them

People tend to overvalue what belongs to them relative to the value they would place on the same possession if it belonged to someone else. This “endowment effect,” helps explain why most people would demand at least twice as much to sell a ticket to the inaugural ball than they would to buy it.

The stock does not know that you own it. People who pick their own lottery ticket demand four times the price for selling it than people who are given it randomly

Tendency to fall in love with our own ideas

Richard Thaler

Average Offer: $5.25

Average Bid: $2.75.

Half the students in a Cornell economics class were given a mug emblazoned with the school’s logo. The mug, which sold at the campus bookstore for $6, was examined by all the students—those who had just received them as a gift and those who hadn’t. Given that the mugs were handed out randomly, it is unlikely that those who received the free mugs loved coffee (or Cornell) more than the students who did not. Thaler then conducted an auction to see how much money the mug owners would require to part with their ceramic cups and how much the students who didn’t have mugs would pay to own one.

The median price below which mug owners were unwilling to sell was $5.25, on average. That is, they wouldn’t give up their newfound possession for less than that amount. Conversely, the median price above which mug buyers were unwilling to pay was about $2.75.

Loss Aversion Causes Endowment Effect

If she owns the cup, she considers the pain of giving it up. If she does not own it, she considers the pleasure of getting the cup. Giving up the cup is more painful than getting one is pleasurable.

We hold on to things, because we hate losing them.

In fact, endowment effect at the subconscious level.

Endowment effect at the subconscious level.

Compare what you own with what you don’t own!

Endowment effect is not universal. If someone asks you to exchange Rs 500 note for five Rs 100 ones, you won’t experience this effect. Things we hold for exchange vs. things we hold for use.

What about stocks? Investors who get emotionally attached to their stocks are being irrational.

But what about BRK? Survivorship bias.

Gordon Gekko’s Lesson: Don’t get emotional. Think like a trader.

“Veteran traders have apparently learned to ask the correct question, which is How much do I want to have that mug, compared with other things I could have instead? This is the question that Econs ask, and with this question there is no endowment effect, because the asymmetry between the pleasure of getting and the pain of giving up is irrelevant.” - Kahneman

Biased Assimilation and Attitude Polarization

How many of you support death penalty? How many oppose it?

Two groups of Stanford University students were asked these questions. People had extreme views. Either they vehemently supported death penalty or they vehemently opposed it. So far so good.

Now both groups were given two well-written research articles to read on the subject. One study argued in favor of death penalty, and the other one argued against it.

Its reasonable to assume that people who read the docs would have become a bit more tolerant towards the views of those who disagreed with them. In other words, views of the two groups, were were poles apart should have come closer after each student had read the “other side of the arguments.”

If these students were rational, they might conclude that the issue is a complex one and accordingly the two groups might move closer to each other beliefs about death penalty. The opposite happened! - the were now even more poles apart - they clasped the confirming article to their bosoms and found faults in the other.

Lord, Charles, Ross, Lee, and Lepper, Mark (1979). 'Biased Assimilation and Attitude Polarization: The Effects of Prior Theories on Subsequently Considered Evidence',Journal of Personality and Social Psychology, 37 (11): 2098-2109.

This idea which was the subject matter of this document is a very powerful idea in investment management. Analysts routinely pick up evidence that supports their prior beliefs and discredit disconfirming evidence..

“This is a world inhabited not by people who have to be persuaded to believe but by

people who want an excuse to believe.”- John Kenneth Galbraith

People want to latch on to just about any reason to do what they have already decided to do...

We are biased not only about the kind of information we examine, but also about the amount of information we examine.

“Stopping rule”

We do not process information in an unbiased manner. We distort it to fit our preconceived notions. When we find confirming evidence, we stop searching. When initial evidence disconfirms our belief, we dig deeper to either find sufficient confirming evidence which will outweigh disconfirming evidence or evidence that discredits our initial disconfirming evidence. And then we stop searching.

In probabilistic terms, this methodology dramatically increases our chances of finding evidence that supports our belief. If you look hard enough for evidence that supports your belief, you WILL find it. Data data everywhere, pick what you like that will reinforce what you already believe…. - this is a very BAD algorithm….

I’ve rarely seen a “strong buy” recommendation in a research report which also lists points which could prove that conviction wrong. Is the author blind? Is there nothing which could prove him/her wrong?

“If you're doing an experiment, you should report everything that you think might make it invalid — not only what you think is right about it... Details that could throw doubt on your interpretation must be given, if you know them. “The exception tests the rule. Or, put another way, “The exception proves that the rule is wrong.” That is the principle of science. If there is an exception to any rule, and if it can be proved by observation, that rule is wrong.”

Backward thinking

Proposition: All Swans are White

How will you prove it?

You can’t. Because even if you sign a billion swans and all of them are white, that does not prove that ALL swans are white.

But a single sighting of a black swan can DISPROVE the claim that ALL swans are white.

So, you just have to give a lot of weightage to things that disprove notions. They are terribly important. But the human mind does the exact opposite.

What you see above is a contradiction. Thats an INCREDIBLE USEFUL trick, you learnt in high school. For example how do you prove that square root of 2 is an irrational number. Well you do it by using “proof by contradiction.” or “Reductio ad absurdum”

To prove a proposition to be true, first assume it to be false, then prove that if it is false, it will lead to an obvious contradiction, therefore the proposition must be true.

I am going to have 10 kids. Whats the probability that I will have at least one girl?

Ans: 99.9023%. How did I solve this?Forward: P(1)+P(2)+P(3).......+P(10)Backwards = 1-P(10 boys) = 1 - (0.5)^10

They taught it to you at school and then that was it! Well you need to use this trick a LOT in life to solve problems become some problems are better solved when we invert them.

“Invert! Always Invert!” - Carl Jacobi

“It is an old maxim of mine that when you have excluded the impossible,

whatever remains, however

improbable, must be the truth.” –

Sherlock Holmes

So you’ve got to think like Sherlock Holmes, and many great scientists who think exactly like this. They look for contradictions as in “this can’t be explained by this, nor by that or that, therefore there is only one explanation left which must be THE correct explanation.”

Read this book to see how Judith Rich Harris used this methodology in her remarkable work:

Amazon.com: No Two Alike: Human Nature and Human Individuality (9780393329711): Judith Rich Harris: Books

http://www.amazon.com/No-Two-Alike-Nature-Individuality/dp/0393329712/

Also read this:

Annals of Behavior: Do Parents Matter? : The New Yorker

http://www.newyorker.com/archive/1998/08/17/1998_08_17_054_TNY_LIBRY_000016171

See how Ralph inverts the problem and disproves something by coming to an absurd conclusion:

“Remember back in the early '80's when the hard disk drive for computers was invented? It was an important, crucial invention, and investors were eager to be part of this technology. More than 70 disk drive companies were formed and their stocks were sold to the public. Each company had to get 20 percent of the market share to survive. For some reason they didn't all do it . . .” – Ralph Wanger

“When we buy a stock, we always think in terms of buying the whole enterprise because it enables us to think as businessmen rather than stock speculators. So let’s just take a company that has marvelous prospects, that’s paying you nothing now where you buy it at a valuation of $500 billion. If you feel that 10% is the appropriate return and it pays you nothing this year, but starts to pay you next year, it has to be able to pay you $55 billion each year – in perpetuity. But if it’s not going to pay you anything until the third year, then it has to pay $60.5 billion each per year – again in perpetuity – to justify the present price… I question sometimes whether people who pay $500 billion implicitly for a business by paying some price for 100 shares of stock are really thinking of the mathematics that is implicit in what they’re doing. For example, let’s just assume that there’s only going to be a one-year delay before the business starts paying out to you and you want to get a 10% return. “If you paid $500 billion, then $55 billion in cash is the amount that it’s going to have to disgorge to you year after year after year. To do that, it has to make perhaps $80 billion, or close to it, pretax. Look around at the universe of businesses in this world and see how many are earning $80 billion pretax – or $70 billion or $60 or $50 or $40 or even $30 billion. You won’t find any…

Market Cap: Rs 68,000 cr.

Market Cap: Rs 2,900 cr.

Down 96%

Oct 2007: Market Cap: Rs 46,000 cr.

Invert. Reverse engineering...

Reducing to problem to a discipline which is more fundamental than your own discipline.

Wanger and Buffett used the principle being discussed here - proof by contradiction.

Wanger used the method to prove that the market was wrong in its AGGREGATE valuation of disk drive companies.

Buffett used the technique to prove that the market was wrong in valuing dotcoms at those ridiculously high valuations that existed in early 2000 (when he gave that talk).

You MUST learn this trick - proof by contradiction. You can take the market value of a company and work backwards to figure out what the company will have to achieve in the future to justify its current valuation and then show that “this is absurd” and bingo you have your proof that the stock is mispriced.

Backward Thinking FREES you from making predictions which you know will have a high error rate. Ask why would something happen? Why would it not happen? What can cause me to be wrong about this notion? Why would this trend that is hypnotizing me NOT reverse? Because if you see a trend, you will put an arrow at the end of the trend line implying that it will continue and then you will go out looking for things that reinforce your belief that the trend will continue. You need to BREAK this HABIT by FORCING OBJECTIVITY. One way to do that is by using backward thinking you ask what the three reasons why this is a lousy idea?

“The test of a first-rate intelligence is the ability to hold

two opposing ideas in mind at the same time and still retain

the ability to function.” - F. Scott

Fitzgerald

Another way to deal with bias from commitment and consistency is to learn to live with doubt.

The human mind HATES keeping contradictory thoughts in it. It wants to QUICKLY RESOLVE COGNITIVE DISSONANCE. And most of the time people resolve it by FOOLING THEMSELVES.

Don’t YOU do that…

Read this book to discover other people who have minds like the one described by Fitzgerald above:

Amazon.com: The Opposable Mind: How Successful Leaders Win Through Integrative Thinking (9781422118924): Roger L. Martin: Books

http://www.amazon.com/dp/1422118924

Richard Feynman Video on Doubt and Uncertainty.

YouTube - BBC interview with Feynman (uncertainty)

http://www.youtube.com/watch?v=_MmpUWEW6Is

Another way to deal with the bias from commitment and consistency principle by emulating the jury system of decision making.

So what happens in a jury system?

12 not so angry men (or women) who are honorable and have no connection with the case are required to sit in a room and listen. They are not allowed to talk - the talking is done by the lawyers and the witnesses and the judge. The jury members are required to keep them minds open and their mouths shut and hear the proceedings of the case including the arguments brought forward by both sides. They are required to NOT DECIDE AT THIS POINT.

Then they are asked to go sit in a room and NOT COME OUT until they have a UNANIMOUS (or majority in some countries) decision. To arrive at the decision, they need to debate, discuss, look at different points of view, and only AFTER this has been done are they required to DECIDE.

This is a WONDERFUL system of decision making because it forces objectivity, removes first conclusion bias, and confirmation bias - IF IT WORKS. In reality, psychologically astute lawyers will use all the tricks in the trade to manipulate jury members - but at least in theory the jury system is a fabulous system - and strongly advice you to adopt it.

Dealing with Confirmation Bias:

Wear the Mask of Objectivity

Suspending judgment

Another idea for dealing with this bias is move people around. When guards change, the new guard can take hard decisions which the old one found too hard to take because they were too emotionally invested in them.

New generations are less brain-blocked by previous conclusions

Successful corporate restructuring plans almost always done by an outsider...

Need to change your mind in light of new facts which change

the odds

Finally, you’ve got to learn how to deal with SURPRISE.

After all all disconfirmation evidence is SURPRISE. Research shows that people are too slow to change an established view - even Einstein found it hard, in his later years to adjust to the reality of quantum mechanics. If one is the best minds found it hard, people like you and me are going to find it HARDER...

Science progresses when the scientists find something they’re NOT looking for - the so-called “accidental discoveries”. Read the following to learn more:

Amazon.com: Serendipity: Accidental Discoveries in Science (9780471602033): Royston M. Roberts: Books

http://www.amazon.com/Serendipity-Accidental-Discoveries-Royston-Roberts/dp/0471602035/

I think “Serendipity” is a very beautiful word…

Great scientists know how to deal with surprise. We can learn a lot from people who dealt with “surprise” appropriately….

You’ve just got to learn how to deal adequately with surprise - in your professional as well as personal lives. Changing minds in light of new facts is a very valuable habit to acquire and maintain….

“When facts change, I change my mind. What do you do Sir?”

- John Maynard Keynes

Thank You