Secondly, analysts fail to understand that earnings growth is a highly mean reverting process over a five year time period. The base rate for mean reversion is very high. The low growth portfolio generates nearly as much long term earnings growth as the high growth portfolio. Effectively, analysts judge companies by how they appear, rather than how likely they are to sustain their competitive edge with a growing earnings base.
These mistakes lead us to our eighth rule (8) Don’t confuse good firms with good investments, or good earnings growth with good returns. Our minds are not supercomputers, and not even good filing cabinets. They bear more resemblance to post-it notes which have been thrown into the bin, and covered in coffee, which we then try to unfold and read the blurred ink! In particular the ease with which we can recall information is likely to be influenced by the impact that information made when it went in. For instance, which is a more likely cause of death in the US, being killed by a shark attack, or being killed as a result of a lightening strike? Most people go for shark attacks. Largely this is a result of publicity that shark attacks gain in the media, and the fact that we can all remember the film Jaws.
In actual fact, the chances of dying as a result of a lightening strike are 30x greater than the chances of dying from a shark attack. A less drastic example comes from Kahneman and Tversky (1973). They asked people the following: ‘In a typical sample of text in the English language, is it more likely that a word starts with the letter k or that k is its third letter?’. Of the 152 people in the sample, 105 generally thought that words with the letter K in the first position were more probable.
In reality there are approximately twice as many words with k as the third letter as there are words that begin with k. Yet because we index on the first letter, we can recall them more easily. Think about this in the context of stock selection. How do you decide which stocks you are going to look at when you arrive at work in the morning? Is it because you read about them in the Financial Times? Or heaven forbid, that some broker sent you an email mentioning the stock, or some analyst wrote a research report on it? It is worth noting that Gadarowski (2001)[3] investigated the relationship between stock returns and press coverage.
He found that stocks with the highest press coverage underperformed in the subsequent two years! Be warned all that glitters is not gold. (9) Vivid easy to recall events are less likely than you think they are, subtle causes are underestimated. Our final bias beater is best explained by offering you the following bet. You are offered a bet on the toss of a fair coin, if you lose you must pay £100, what is the minimum amount that you need to win in order to make this bet attractive? There are, of course, no right or wrong answers. It is purely a matter of personal preference.
The most common answer is somewhere between £200-£250. That is to say that people feel losses around 2-2½ times more than they feel gains. The chart below shows the outcomes when I asked this question of a set of colleagues at a previous employer (still an investment bank).
The mean answer is around the £200 mark. There was also a considerable number of individuals who required massive compensation in order to accept the bet – perhaps they just didn’t trust a strategist! It is noteworthy that some players would have accepted the bet for £50...it is giving nothing away when I tell you that the person who was willing to accept this sum was a tech analyst. This told me everything I needed to know about tech analysts’ ability to value companies! There is a serious point to all of this. People hate losses (loss aversion) and find them very uncomfortable to deal with in psychology terms. Because losses are so hard to face, we tend to avoid them whenever possible.
For instance, a loss isn’t perceived as a loss on some level so long as it is not realized. Therefore losses will be realized infrequently, in the hope that they become winners (over-optimism again!). This tendency to ride losers and sell winners is known as the disposition effect. Even if we are right (and most of the time we aren’t) that our losers will become winners there will be better opportunities to put the trade on lower down, rather than riding the position all the way down. This generates our final bias beater (10) Sell your losers and ride your winners.
This isn’t a comprehensive survey of biases and their impact. We haven’t addressed any of the emotional aspects of investment or indeed any of the social aspects (such as herding). However, the rules we have set out should help guide us to better decisions. All too often when we present on behavioural finance, institutional investors think that it applies to private clients and not to them. This is surely a prime example of the illusion of knowledge creating over-confidence. At the end of the day, each and every fund manager is an individual too. They too will be subject to the biases outlined above.
Being aware of the mistakes we make is the first step. To really avoid them takes a great deal of practice. After all, how many of us can remember how to perform long division by hand? Without regular use skills recede in our minds, and we will continue to fall into the regular pitfalls outlined above. Perhaps the best defence of all is to design an investment process that deliberately seeks to incorporate best mental practice!
3 S Gadarowski (2001) Financial press coverage and expected stock returns, Cornell University Working Paper
By Dr James Montier
Summary: Index