Situational Bias: Key to Stock Market Profits

I'm always asking myself, how it's possible that I've made money investing in the stock market. What is the intellectual basis for some of the investment strategies I follow?

One idea, I've become convinced of, is that situational bias is a major cause of investment opportunities.

Situational bias, sometimes called recency bias, refers to the fact that we as humans tend to think that events will continue in the future as they have in the most recent past. Basically, we are intellectual prisoners of our current circumstances. We cannot see how things can and do change, for better or worse.

The reason why this bias plays an important role in investing is because in many instances it is nearly impossible for people to see how a company's financial condition can change dramatically in the future. Basically, we see companies and evaluate them based on their recent performance, failing to spot significant changes that may vastly improve (or degrade ) the company's finances. A company is losing piles of money and we can't see how it can ever make money. Or a company is minting money and we can't see how it will suddenly lose money. So inevitably we "overvalue" those companies with strong recent financial results, and "undervalue" those with weak recent performance.

In order to make money investing, however, one needs to spot situations where this situational bias is potentially wrong. One has to spot certain changes that can turn a weak performer into strong performer, or vice versa . Successful investing is about spotting changes and turning points, and being able to intellectually conceive of a situation that is dramatically different than the one the Market perceives of today.

You can make money in these situations because situational bias is so strong that it will take several quarters or even a bit longer for the Market to finally believe that things are getting better (or worse). This time lag due to situational bias is what opens up the opportunity for investment profits.

Inevitably the key question becomes: Where can one find situations where situational bias is strongest and what clues are there that the bias is false, i.e. the future is about to be vastly different than the recent past?