Capitalizing On Human Weaknesses

Researchers have found investors are not rational and because of this, many US asset management firms invest based on behavioral finance theories.

Take a crack at the problems below. Assume the following information: 1) The probability that a woman has breast cancer is one per cent. 2) If she has breast cancer, the probability that the radiologist will correctly diagnose it is 80 per cent. 3) If she has a benign lesion (no breast cancer), the probability that the radiologist will incorrectly diagnose it as cancer is 10 per cent.

The question: What is the probability that a woman with a positive mammogram actually has breast cancer? Ninety-five of the 100 physicians presented with this problem (Eddy 1982) estimated the probability to be about 75 per cent.

Does that sound about right? Not even close. The correct probability, as given by Bayes' rule (a theorem in probability), is 7.5 per cent.

Try another Q: What is the probability that a 20 to 30-year-old Singaporean male who does not engage in risky sexual behavior is in fact infected with HIV if he gets a positive result on an Aids test?

The background information is as follows: 1. The prevalence rate is 0.01 per cent. 2. The sensitivity of the test is 99.8 per cent. 3. The false positive rate for the test is 0.01 per cent.

Clearly, this is a tremendously accurate test, identifying almost everyone who has the virus while hardly ever incorrectly identifying an HIV-negative man as positive.

So if the test says a man has the virus, what is the probability that he really does? Or asked another way, what is the probability of an uninfected man being tested positive for HIV? The answer: 50 per cent.

Here's how you work out the probability. Imagine 10,000 men in the low-risk group taking the test. One of them is infected (the prevalence rate is 0.01 per cent). He will almost certainly test positive (the sensitivity of the test is 99.8 per cent).

Of the remaining 9,999 uninfected men taking the test, one will also test positive (the false positive rate for the test is 0.01 per cent). So two men test positive; one actually has the virus, the other doesnt. Therefore, if a man from the low-risk group tests positive, the probability that he has the virus is about 50 per cent.

We can come away with a few lessons from the above problems.

First, probability can be a difficult concept to grasp. Often, our intuition about the likelihood of an event occurring may be flawed. I

used the above two problems to illustrate the cognitive errors that we all make. Such errors or biases can lead to irrational decisions, including investment decisions.

A substantial amount of work has been done in the field of behavioral finance. Many researchers are of the opinion that such biases are consistent enough to be exploited for profit.

Indeed, US asset management companies such as LSV Asset Management, Fuller & Thaler, David Dreman, Ken Fisher and Martingale invest based on behavioral finance theories. The investment philosophy of LSV - which manages US$8.5 billion worth of assets - is to exploit the judgmental biases and behavioral weaknesses that influence the decisions of many investors.

These include: the tendency to extrapolate the past too far into the future, wrongly equating a good company with a good investment irrespective of price, ignoring statistical evidence and developing a mindset about a company.