When biases collide

Here's Leicester manager Nigel Pearson talking about tonight's game against Man City:

Do I expect any backlash or do I take encouragement from their recent results? I think a bit of both.

This is an example of how mistaken beliefs can cancel out. On the one hand, we have the hot hand fallacy (well, cold hand in this case); the idea that unusually bad performance persists*. On the other, there's the gambler's fallacy; the idea that a run of unusually bad outcomes increases the likelihood of a good one. In giving equal weight to both errors, Mr Pearson has come to a reasonable judgment.

This is an example of how cognitive biases can cancel out to produce an accurate opinion.

I suspect it's not an isolated instance. Bayesian conservatism - under-reaction  - might sometimes offset over-reaction: behaviouralfinance.net has entries for both.  

A new paper by Thomas Eisenbach and Martin Schmalz give us another example. Overconfidence, they say, might be used as a commitment device.

This is because many of us have time-inconsistent risk preferences: we don't worry about future risks until they are imminent, when we panic. For example, you might sign up for a charity parachute jump but then panic on the day. And actors and musicians feel stage fright just before they perform even though they chose to enter professions where they knew they'd have to go on stage. For retail investors, such preferences can be expensive. It can cause them to have heavy equity exposure in normal times, only to get cold feet when volatility increases, thus causing them to sell when prices are temporarily depressed.

Overconfidence, they say, can solve these problems. The investor who is overconfident about his abilities might think when shares fall "the market's being stupid; it'll come round to my way of thinking soon". This might be irrational overconfidence, but it saves him from the temptation to sell at the bottom. Similarly, the mediocre actor can overcome stage fright by telling himself that he's going to deliver a great performance.

I suspect that a lot of what we call rational behaviour is in fact the cancelling out of biases. This might occur within particular individuals, as in Mr Pearson's case. Or it might occur within groups. Maybe one reason why the stock market is (sometimes? often?) efficient isn't that all its participants are rational but rather that those who over-react offset those that under-react; experiments show that stupid traders can produce rational markets. There's (sometimes) wisdom in crowds and (often?) benefits to cognitive or ecological diversity because irrationalities can net out. This is why we often prefer committees to individual decision-making.

There's a political implication here. If we look only at individual cognitive biases, we'll be tempted to infer that stupidity is everywhere; after all, the list of such biases is a long one. This, though, is a mistake. We need the hard evidence of systematic error before we can infer that biases matter. And sometimes, this is lacking.

Take one example - savings. It's easy to infer from the ubiquity of hyperbolic discounting or akrasia that people are saving too little. If, however, we look at the wealth of those in or approaching retirement, things aren't so plain. And, indeed, it is possible to be overly prudent - to save too much and so deprive one's present self of happiness and one's future self of consumption capital and happy memories.

Perhaps, then, some of us overstate the amount of irrationality around us. Worse still, there might be unpleasant political motives for doing so.  

* There's some doubt about whether the hot hand fallacy really is a fallacy. However, any Gooner seeing Olivier Giroud's performance against Monaco last week - when he missed a series of chances even though he went into the game in good "form" - will suspect it is indeed a fallacy. (This point might itself be an example of over-reaction).

Comments

[Roy Lonergan]

Chris
Some unusual coverage for your local team. What fallacy/bias resulted in you becoming a gooner?
Roy

[chris]

Roy - the first game I watched on TV was thr 72 Cup final between Leeds & Arsenal. I knew nothing about football except that I hated Leeds, so Arsenal it was and stayed. Also, I liked the shirts.
Oddly, in the early 70s, City were actually a better team than Arsenal & I was the only Gooner at school. Always the rebel.

[Roy Lonergan]

Hating Leeds - so neither a fallacy nor a bias. Sadly the first game my Dad took me to was at West Ham so I've been blighted ever since (1980 excepted).

[Roy Lonergan]

Chris - if you're looking for themes for football related posts, how about people ignoring regression to the mean (I think this is different from hot hand?). For example, Big Sam taking a lot of unwarranted stick because of the order of what on average are a set of results showing progress. .

[Metatone]

I've often been annoyed by the fallacy stuff, because on the one hand we have the gambler's fallacy, but we also have reversion to the mean.

How do you identify Pearson (esp. talking about Man U.) as a gambler, gambling on a run of bad performances resulting in a good one, as opposed to some expectation that the bad performances are not the mean?

[marcel proust]

So, in that famous unpublished paper, when Larry Summers asserted, "“THERE ARE IDIOTS. Look around.”, was he merely being overconfident, or was he focusing on the wrong thing? or both?

https://www.google.com/search?client=opera&q=Larry+summers+%E2%80%9CTHERE+ARE+IDIOTS.+Look+around.%E2%80%9D

[Icarus Green]

Its fascinating isn't it - idiots cancel out geniuses to provide a stable equilibrium. How should geniuses react to this? Should they assume reversion to the mean in markets? Or should they follow the smart money? And then of course theres the discrete truth that the investment is either fundamentally good or bad that must reveal itself in due time. Or perhaps, halo effects mean the attention idiots give a stock (and if geniuses bandwagon in anticipation, them too) means that the stock will simply fulfill a self fulfiling prophecy. So weird. Causuality seems to go in all directions.