Modules for Investors
Investment Biases - Part 1
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An Overview on Information Processing Bias
Information Processing Bias
In simple terms, Information processing bias means the inability to understand the information in its correct sense and conceiving it irrationally and abruptly. Information processing bias occurs due to multiple reasons, which can be traced to the common point of cognitive bias- a systematic error in understanding judgments, facts and decisions.
Information Processing bias is a cognitive error, much as belief perseverance bias. Belief perseverance bias stands for when an individual doesn’t comprehend any new information because of previous news conditioning. The individual refuses to process a new piece of information because it is hard for them to grasp, breakdown and understand the new situation. They continue to be rigid on the older piece of information. Even when they try, they only process the information relevant to them, match with the thoughts and agree to their understanding.
Information processing bias also agrees with confirmation bias. People naturally pay attention to the information that agrees with their previous beliefs and discards any information they do not want to acknowledge. It is much like paying selective attention to things they like and things they don’t like.
But more than differentiating between the bias as Information processing bias or Confirmation bias, it is much more critical to determine these two between cognitive bias and emotional biases.
A cognitive bias refers to a systematic error when an individual tries to process new information, interpreting and implying this information into the future’s decision-making processes.
When it comes to making sound decisions, there are two ways to go about them. The first one is to gather all the related information, deeply analyze the facts, calculate the consequences of the optional decisions in hand, and make a final call about what to do. The other is to take a tried and tested shortcut, make a broad guess and just go ahead with it.
The second option is called heuristics. Socialist Herbert Simon introduced the theory of bounded rationality, which states that if we suppose the decision-making process is subject to constraints in terms of time and capacity to search for and process information. In that case, the process will be satisfactory rather than properly rational. And if decisions are not adequately sound, how exactly are decisions made?
Suppose there is a piece of rumored information about a company that is about to go bankrupt. When this information comes out, the investors start to sell their stocks in the company. Naturally, they start googling about the latest news on the company to keep track of things. Amidst the news based on confirmation of the company’s bankruptcy, the investors miss out on the story which talks about the latest product launch which has received great love from the consumers and is much likely to do good. So if the investors had retrieved the stock, they would have shared the all-time high the company received when the product profited the brand.
This is an example of heuristic decision making which came across due to the Information processing bias. Information processing bias includes multiple heuristics like anchoring and adjustment bias, mental accounting bias, framing bias, availability bias, self-attribution bias, outcome bias, and recency bias. Let’s discuss them further-
Anchoring and adjustment bias- In this case, the investor “anchors” or fixes themselves with the first information they receive and then adjust any new information that they receive with regards to this fixed point. No matter what the information may target or need to convey, the bigger umbrella of anchored news is always covering the new information.
Mental accounting bias- Mental accounting bias depends upon the provided money divided for different uses intended for it already. For eg- Money for school fees, money for tuition, etc.
Framing bias- Framing bias depends upon the interest of the investor purchasing the object is proportional to the way he is approached. If we try to understand it in literal terms, it suggests the way the question is asked, the investor, can change his answer even when the facts remain the same. For eg- If someone suggests buying a lottery ticket because it can offer a lot of money, one might be interested in purchasing it. But the same thing can disinterest the buyer if he is told about the remote chances of actually winning the lottery.
Availability bias- This means that people tend to favor their decisions that are easily accessible or approachable. It depends on how comfortably the approach can determine the decisions based on proximity.
Understanding information processing bias requires studying the cognitive and emotional errors layer by layer. But now that we have understood the basis of information processing bias, let’s move on to the next chapter, herd mentality.
- Information processing bias stands for the inability to understand new information without altering it to only the facts which are relatable to them.
- It is important to understand the difference between cognitive error and emotional error before filtering the bias between information processing bias, confirmation bias and belief perseverance bias.