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Cognitive Bias And Penny Stocks
Written by troy on Monday, April 27, 2009 | No Comments
Categories: Uncategorized Tags: Human Phenomenon, Long Term Investment
Cognitive Bias And Penny Stocks
Cognitive Bias and Penny Stocks
Cognitive bias is the tendency of intelligent, well-informed people to do the wrong thing. It’s a human phenomenon and is actually a branch of philosophy. It also explains why people, both professional investors and individuals do not capture the gains in the market that they should.
What is Cognitive Bias?
An old colleague of mine mentioned a story over a decade ago that illustrates cognitive bias perfectly. When he would make a speech, he would ask the crowd the quesion: “In the United States, do more people die each year of automobile accidents or heart disease?” He would then ask for a show of hands for each as a vote. In most cases, the audience was evenly split about 50:50 between the two. The actual answer is that heart disease kills more by more than 10:1. Ten times as many people die each year of heart disease than do in accidents.
The view that heart disease and automobile accidents kill equally is an example of cognitive bias. How does this happen? Well, we see automobile accidents all of the time on our own commute, on television and in newspapers.
They are usually graphic, sometimes shocking and are much more easily recalled in our minds. This produces the cognitive bias that causes intelligent people to equate automobile accidents with heart disease as equal killers. Because we see, hear and recall automobile accidents more, our minds push their importance higher than it deserves.
Investing and Cognitive Bias
In study after study, it has been shown that small companies (including penny stocks) with low price/book ratios provide large returns. Large-cap, high price/book stocks systematically underperform compared to these small companies.
Knowing that fact, it would seem that investors would be attracted to the smaller stocks, penny stocks included.
Evidence shows the opposite. In numerous studies, even of professional managers, when asked to rank companies including their expected long-term investment value. Over and over again, these folks ranked the large-cap, high price/book companies above the smaller companies.
Representativeness as an Example of Cognitive Bias
Representativeness is illustrated by an experiment from Kahneman and Tversky (1982)3, the classic text on cognitive bias. The experiment goes like this. A group of people is told about Linda. Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy.
As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in antinuclear demonstrations.
Which event is more probable:
1. Linda is a bank teller
2. Linda is a bank teller and is active in the feminist movement.
87% of those surveyed select #2. They say Linda is a bank teller and an active feminist even though the compound event has to be less likely than the single event. Two-thirds of those selecting #2 said they selected the compound event for some version of similarity or representativeness. The description of Linda is representative of an activist, not a bank teller, so they conclude that Linda is an activist (and, incidentally, a bank teller) even though the compound event must be less likely.
According to Shefrin and Statman, prominent investors overestimate the probability that a good company is a good stock because prominent investors rely on the representativeness heuristic. Good stocks are similar to good companies. Or, good stocks are now good companies. Therefore, they conclude incorrectly that good companies are good stocks.
This is a problem for investing. It is not necessarily so that good companies are good stocks. Companies and their stocks are two seperate things.
What do we Learn?
Basically, investors need to realize the fact that small companies, even those in the penny stock range usually outperform not only the overall market, but especially larger, more expensive companies.
We need to set aside our fear of smaller, unknown companies as those are the ones that hold the most promise.
For example, Microsoft was a small unknown company that came out at $5.00 and for a while, posted nice revenue growth and had great products. However, too many investors stayed clear for a “good” company like IBM. I’m sure many of those investors regret not investing in Microsoft when they had that chance. However, it was their irrational fear of the smaller, unknown companies that prevented them from seeing the promise a company like Microsoft had. In fact, all big companies were once small.
Penny stocks need to be considered for the portfolio of everyone trying to capture higher than average gains.
The irrational fear keeps too many from doing so, but we know better.
By: SD Sokol
About the Author:
Cognitive bias is the tendency of intelligent, well-informed people to do the wrong thing. It’s a human phenomenon and is actually a branch of philosophy. It also explains why people, both professional investors and individuals do not capture the gains in the market that they should.
What is Cognitive Bias?
An old colleague of mine mentioned a story over a decade ago that illustrates cognitive bias perfectly. When he would make a speech, he would ask the crowd the quesion: “In the United States, do more people die each year of automobile accidents or heart disease?” He would then ask for a show of hands for each as a vote. In most cases, the audience was evenly split about 50:50 between the two. The actual answer is that heart disease kills more by more than 10:1. Ten times as many people die each year of heart disease than do in accidents.
The view that heart disease and automobile accidents kill equally is an example of cognitive bias. How does this happen? Well, we see automobile accidents all of the time on our own commute, on television and in newspapers.
They are usually graphic, sometimes shocking and are much more easily recalled in our minds. This produces the cognitive bias that causes intelligent people to equate automobile accidents with heart disease as equal killers. Because we see, hear and recall automobile accidents more, our minds push their importance higher than it deserves.
Investing and Cognitive Bias
In study after study, it has been shown that small companies (including penny stocks) with low price/book ratios provide large returns. Large-cap, high price/book stocks systematically underperform compared to these small companies.
Knowing that fact, it would seem that investors would be attracted to the smaller stocks, penny stocks included.
Evidence shows the opposite. In numerous studies, even of professional managers, when asked to rank companies including their expected long-term investment value. Over and over again, these folks ranked the large-cap, high price/book companies above the smaller companies.
Representativeness as an Example of Cognitive Bias
Representativeness is illustrated by an experiment from Kahneman and Tversky (1982)3, the classic text on cognitive bias. The experiment goes like this. A group of people is told about Linda. Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy.
As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in antinuclear demonstrations.
Which event is more probable:
1. Linda is a bank teller
2. Linda is a bank teller and is active in the feminist movement.
87% of those surveyed select #2. They say Linda is a bank teller and an active feminist even though the compound event has to be less likely than the single event. Two-thirds of those selecting #2 said they selected the compound event for some version of similarity or representativeness. The description of Linda is representative of an activist, not a bank teller, so they conclude that Linda is an activist (and, incidentally, a bank teller) even though the compound event must be less likely.
According to Shefrin and Statman, prominent investors overestimate the probability that a good company is a good stock because prominent investors rely on the representativeness heuristic. Good stocks are similar to good companies. Or, good stocks are now good companies. Therefore, they conclude incorrectly that good companies are good stocks.
This is a problem for investing. It is not necessarily so that good companies are good stocks. Companies and their stocks are two seperate things.
What do we Learn?
Basically, investors need to realize the fact that small companies, even those in the penny stock range usually outperform not only the overall market, but especially larger, more expensive companies.
We need to set aside our fear of smaller, unknown companies as those are the ones that hold the most promise.
For example, Microsoft was a small unknown company that came out at $5.00 and for a while, posted nice revenue growth and had great products. However, too many investors stayed clear for a “good” company like IBM. I’m sure many of those investors regret not investing in Microsoft when they had that chance. However, it was their irrational fear of the smaller, unknown companies that prevented them from seeing the promise a company like Microsoft had. In fact, all big companies were once small.
Penny stocks need to be considered for the portfolio of everyone trying to capture higher than average gains.
The irrational fear keeps too many from doing so, but we know better.
By: SD Sokol
About the Author:
More than a decade of experience working for financial firms is all aspects of trading, research and financial planning.
Currently the President of FalconStocks.com and WaveStocks.com