This leads to our third rule (3) Don’t get hung up on one technique, tool, approach or view. Flexibility and pragmatism are the order of the day. We are inclined to look for information that agrees with us. This thirst for agreement rather than refutation is known as confirmatory bias. The classic example is to consider four cards, each card carries one alpha-numeric symbol, the set comprises of E, 4, K, 7. If I tell you that if a card has a vowel on one side, then it should have an even number on the other, which card(s) do you need to turn over to see if I am telling the truth? Give it some thought. Most people go for E and 4.
The correct answer is E and 7, only these two cards are capable of proving I am lying. If you turn the E over and find an odd number then I was lying, and if you turn the 7 over and find a vowel then you know I was lying. By turning the four over you can prove nothing, if it has a vowel then you have found information that agrees with my statement but doesn’t prove it. If you turn the four over and find a consonant, you have proved nothing. At the outset I stated a vowel must have an even number, I didn’t say an even number must have a vowel!
By picking four, people are deliberately looking for information that agrees with them. Our natural tendency is to listen to people that agree with us. It feels good to hear our own opinions reflected back to us. We get those warm fuzzy feelings of content. Sadly, this isn’t the best way of making optimal decisions. Instead of listening to the people who echo our own view we should (4) listen to those who don’t agree with us. The bulls should listen to the bears, and vice versa.
You should pursue such a strategy not so that you change your mind, but rather so you are aware of the opposite position. Our final bias under those related to self deception is hindsight bias. It is all too easy to look back at the past and think that it was simple, comprehensible and predictable. This is hindsight bias – a tendency for people knowing the outcome to believe that they would have predicted the outcome ex ante. The best example I can think of is the US stock market over the last few years. Now pretty much everyone agrees that the US market witnessed a bubble, but calling it a bubble in 1998/99/00 was an awful lot harder than it is now!
This faith in our ability to forecast the past gives rise to yet more bias towards overconfidence. This gives rise to our fifth rule (5) You didn’t know it all along, you just think you did. It is now time to move from self-deception to heuristic simplification. Heuristics are just rules of thumb for dealing with informational deluge. In many settings heuristics provide sensible short cuts to the “correct” answer, but occasionally they can lead us to some very strange decisions. This second group of biases effectively represents information processing errors.
They cover biases that result from the admission that we aren’t super computers capable of infinite dynamic optimisation. When faced with uncertainty people will grasp at almost anything when forming opinions. In the classic experiment Tversky and Kahneman (1974) asked people to answer general knowledge questions such as what percentage of the UN is made up of African nations? A wheel of fortune with the numbers 1 to 100 was spun in front of the participants before they answered. Being psychologists Tversky and Kahneman had rigged the wheel so it gave either 10 or 65 as the result of a spin.
The subjects were then asked if the answer was higher or lower than the number on the wheel, and also asked their actual answer. The median response from the group that saw the wheel present 10 was 25, and the median response from the group that saw 65 was 45! Effectively, people were grabbing at irrelevant anchors when forming their opinions. This is known as anchoring. Think about this in the context of valuation. In the absence of any reliable information, past prices are likely to act as an anchor to current prices. Does it not strike you as strange that the average analysts price target is 28% above current market price?
Too many DCFs are anchored around current market prices. I have even heard some analysts deliberately seek to arrive at a DCF target that is close to market price. One way in which to overcome this bias is to turn the DCF on its head (reverse engineered). Take the market price and back out what it implies about future growth, then compare these with the forecasts.
This should help mitigate the anchoring bias. The other element to beware of is relative valuation. All relative valuation measures should be ignored. It is simply far too easy for an analyst to fixate (anchor) on her sector average as the ‘correct’ value. For instance, in the past I have been asked by analysts to construct tables of valuations on criteria such as PE and Price to book across industries, so that the analyst can compare the stock under investigation with its peer group.
This tells us nothing about the true ‘fair value’ of the equity. The tendency to anchor provides our sixth rule (6) Forget relative valuation, forget market prices, work out what a stock is worth (use reverse DCFs).
By Dr James Montier
Next: When is a buyback not a buyback?
Summary: Index