Confirmation Bias – Understanding Behavioral Biases in Finance

Confirmation bias is the inclination to seek or make sense of news or facts in a way that validates one’s preconceptions. So, during the decision making process for psychologist they will refer to information that supports their decision more favorably. They will rarely give the obvious negative much consideration and since our beliefs and postulations are definitely prejudiced so the tendency to give more attention and weight to data that support our beliefs than we do to contrary data will subtly but gradually have a harmful effect.

An illustration of Confirmation Bias

A very real manifestation of this tendency can be observed in the virtual world. For instance, investors are increasingly turning to message boards or virtual communities to search, clarify, and exchange information before making investment decisions. The volume of discussion on such portals is so intense that it has become possible to sense stock sentiments from here. These message boards have been shown to provide more accurate and timely information than forecasts by analysts.

The reason so many investors even turn to these online communities is to gain an unbiased evaluation of the market conditions, a third-party opinion on something they might not have comprehensive information about, and the 360 degree view of the situation that can help in formulating a successful investment strategy. What in turn happens is that psychological biases, especially in such uncertain and noisy environments, affect the processing of information through these portals leading to short-sighted or impaired decision making.

It can be debated that investment-related message boards and communities do not necessarily benefit potential investors by helping them make unbiased and informed decisions, primarily because investors search for specific information on these portals that align with what they already believe.… Read the rest

Market Timing for Investors

persoMarket Timing is a top down view of the stock market and its prospects. Market Timing is an approach that attempts to determine when to be in the market, when to be out of the market and when to short (bet on a price decline by borrowing stock and selling with the hope to buy it back at a cheaper price and repay at cheaper prices). Market timing includes the following four components.

  1. Trends of interest rates: The future behavior of interest rates, i.e., the tightening or easing bias of the Central Bank. Interest rates are critical to market values for three reasons. Stocks are basically the present value of future earnings. An investor invests his money in an expectation of certain rate of return. The higher the general level of risk-free rates, the greater the expected rate of return and the lower the present value of future returns. Additionally, higher rates of return available in fixed income instruments drain money from the stock market by reason of deteriorating supply and demand dynamics. Finally, many companies employ debt in their capital structure. Higher borrowing costs hurt earnings. Lower rates or the expectation of lower rates has the opposite effect.
  2. Investor sentiments: This is also a contrarian’s indicator. The more bullish the investor sentiment, the more bearish it is for the market. Various proxies are used to determine investor sentiment, including investor surveys as well as ratios of put premiums to call premium, mutual fund cash, new issues of new stocks versus all stocks in the benchmark index, etc.
Read the rest

What Is Plastic Money?

A plastic money card is a thin card that contains identification information such as a signature or picture, and authorizes the card holder to charge purchases or services to the card holder’s account. Today, the information on the card is read by automated teller machines (ATMs), banks, and the internet.

It all started in the 1920s, when individual companies (such as oil companies and hotels) issued these “plastic money cards” for purchases made at their businesses. However, these cards could not be used outside of the company.

In the 1950s a “universal card” was introduced by Diners Club, INC. This was when credit cards were made. These cards allowed the card holders to use the cards in various locations and businesses. The way the cards worked was that there were annual fees, and depending on the plan, the card holders were billed either monthly or yearly.

Later on the “bank credit card system” was introduced. Under this system, the bank credits the account of the merchant at each sale and bills to the card holder at the end of the billing period to account for the sale. The card holder, in turn, pays the bank either the entire balance or in monthly installments with interest. This is the system that all credit cards are under today. Now there are three different types of cards: credit cards, debit cards, and prepaid cards.

Credit cards are cards that offer customers and businesses short-term lines of credit. This allows for the customer to pay for unexpected/large expenses without actually paying for the product that second.… Read the rest