Big Money Thinks Small: Biases, Blind Spots, and Smarter Investing

The degree of one’s emotion varies inversely with one’s knowledge of the facts—the less you know, the hotter you get.

—BERTRAND RUSSELL

PSYCHOLOGISTS CLAIM THAT HUMANS systematically make predictable errors of judgment—particularly in complex, ambiguous situations like the stock market, where the problems are not clearly structured (unlike casinos) and the answers are draped in randomness. Investing forces you to reach conclusions with inadequate data. No wonder we choose based on the information right in front of us, neglecting evidence we can’t see, or latch onto a well-told story rather than digging into complexity. Stories are about unique events, not statistical groups, so we either don’t calculate odds or else miscalculate them, using the wrong reference point. This chapter covers the ways psychological biases misinform our investments, and how the stock market charges us for certain emotions and behaviors and pays us for others.

We tend to weight information based on its availability (ease of recall), because our System 1 thinks What You See Is All There Is. This WYSIATI means that it’s the recent, dramatic, unexpected, and personally relevant images that jump to mind. What doesn’t come to mind is historical, statistical, theoretical, and average. Even with work, a stock’s value is opaque. Instead, the shortcut is: today’s news is good, so buy the stock. Such investors blow with the wind, claiming their actions are “data dependent.” Every reasoned decision is based on data. Which data? Why?

After a crash, the risks of stocks are front and center, whereas late in a bull market, the stellar returns of risky glamour stocks are more prominent. Extrapolating the recent past leads to buying expensive stocks and selling cheap. Likewise, the funds and asset classes that have done well this quarter make headlines; the fact that stocks have typically outearned Treasury bills over most long periods does not. During industrial booms, the record profits of deeply cyclical businesses are reported, without remarking that not so long ago they lost money, and will again. The emissions scandal and car recall plaguing Volkswagen in 2016 sent its stock plummeting. The scandal may bear on the question of whether Volkswagen was well positioned and well managed, but is so shocking that it overwhelms any attempt to answer it. A different question was substituted and answered: Sell the stock! Now!

Instead, shine a spotlight on the evidence that is silent. Lurking in the background are unexamined assumptions about society and institutions. To fix recency bias, study history—the longer and broader, the better. To envision the future, investors need some idea of the normal baseline. Discover which things change and which endure. Statistics, probability, and the outside view are key. History is especially important because people repeat what works, but in the stock market we don’t get timely feedback on our decisions—and what we do get is mostly noise.

The downside of history is the narrative fallacy. In The Black Swan (2010), Nassim Taleb wrote:

The narrative fallacy addresses our limited ability to look at sequences of facts without weaving an explanation into them, or, equivalently, forcing a logical link, an arrow of relationship, upon them. Explanations bind facts together. They make them all the more easily remembered; they help them make more sense. Where this propensity can go wrong is when it increases our impression of understanding.

In other words, a problem arises when we see causation where there is none.

If we’re more inclined to believe dubious stories when they’re palpable, visible, personal, emotionally appealing, unusual, and confirm what we already believe, then we should move in the opposite direction. Push toward longer, multiple histories, comparative history, statistical history, and theory generally. Still, data mining is a growth industry, and it’s never been easier to come up with spurious correlations between the prices of Amazon stock and silver, or the S&P 500 and butter production in Sri Lanka. Investors need an explanation that holds up over time, plus numbers, plus skepticism throughout.

It Wasn’t Inevitable

One outgrowth of the narrative fallacy is hindsight bias, the revisionist history tendency to think that an outcome was inevitable and predictable all along. But, really, the needed information wasn’t available. Personally, I combat hindsight bias by keeping company files, intermittently noting reasons for my trades. Others keep an investment diary. This might include a premortem, in which one mentally time travels, finds that one’s decision has turned out poorly, and conjectures the reasons for the flop. Often when I refer back to notes, I find that the original reason for buying has been replaced by a new one, which can be even stronger, or may be a sell signal. I was originally interested in Monster Beverage for its natural fruit drinks, but the stock’s gains were being driven by explosive growth in its energy drink. Conversely, energy company asset values based on $110 oil looked silly when the oil price was $45.

Anchoring

Because stories are appealing, we often begin with the wrong (statistical) reference point, which is called misplaced anchoring. Sometimes people are highly suggestible and, when prompted with an irrelevant number, anchor on it. For example, investors often can’t bring themselves to sell a stock for less than their cost, hoping to get back to even. (Instead, they should decide based on the intrinsic value of the stock today.) For stocks that have rallied sharply from an absurdly undervalued price, Fidelity fund manager Peter Lynch advised “mental whiteout” of the gains you have missed, in order to focus on today’s opportunity for further gains.

Any single number can be a misplaced anchor—be it a stock’s previous highs, a historical valuation ratio, or estimated earnings. It usually isn’t relevant to compare today’s price/earnings ratio (P/E) for a small-cap or growth stock to its five-year average, because its growth profile and market conditions may have shifted radically. Instead, care about what its P/E should be today, based on what you know, perhaps by comparing it to similar opportunities. It also helps to look at a mosaic of data in assessing value, rather than reducing decisions to one single ratio.

By using the outside view on the proper reference set, you can anchor on better estimates of probabilities. The correct statistical reference category includes all the cases that were similarly placed when the group was formed, including the ones that are no longer around. More data usually produce more reliable predictions. But when you know that a group contains apples and oranges, a narrower reference class is better. Here we must avoid survivorship bias, or studying only the examples that successfully made it through. Later we will investigate why some industries and companies are more prone to failure than others.

More broadly, incorrect anchoring and WYSIATI can lead us to skip steps, thinking we’re nearer to the conclusion than we are. Growing companies are worth more than melting ice cubes. Top-quality businesses can be valued more accurately than junky commodity firms, but identifying an outstanding blue-chip grower doesn’t prove that it’s a buy at any price.

Seek Refuting Evidence

Confirmation bias is the tendency, when you think something is true, to seek evidence to confirm it and ignore refuting facts. The lizard brain makes quick decisions about urgent physical dangers. But when we invest, we need an independent, accurate answer—not a quick one. With everyone digitally connected, it is increasingly hard to avoid the echo chamber. Social networks and other media explicitly try to feed you content that you like and presumably agree with. Investment management has always been a clubby occupation—asset managers have similar backgrounds and shared habits of mind. When a stock goes up after I buy it, and colleagues congratulate me on the score, it’s hard not to take this as proof that I was right. Instead, I should be asking whether I was wrong but lucky and the stock is now overvalued.

Seek out the refuting evidence or bearish story. Invert. Consider whether the opposite story also makes sense. For example, low or negative interest rates are said to stimulate the economy. Inverted: Low interest rates depress the economy by signaling that the government is panicked about the economy (and you should be too)! Savers will have less interest income and so will need to spend less to meet their financial goals. Everything has a shadow side. Find it. Except near bear market lows, every investment usually has some defect, even if it’s just that it’s overpriced. Also, absence of evidence isn’t evidence of absence; just because fraud can’t be proved doesn’t mean it didn’t take place.

Bull

By shutting out refuting evidence, we become vulnerable to overoptimism that our chosen stocks will flourish. Wall Street encourages this tendency because anyone can buy a stock, while only owners can sell. Buy recommendations far outnumber sells. For estimates of a company’s earnings more than a year out and long-term growth rates, reality chronically falls short. Declining earnings are rarely forecast but often occur. This does not apply to predictions of the next two quarters, which, if anything, are slightly low. Companies and analysts tacitly collude to create quarterly “upside surprises.” Skepticism and a comparison of forecasts with past results can counter overoptimism.

Some people can’t handle the truth and are in denial. When there’s a loss, unsuccessful investors try to shift blame. In small doses, we all claim our skill produced good outcomes and blame luck for bad results. But it’s your fault, so sort out what happened. Don’t let loyalty to coworkers or an organization interfere with the search for truth. You can fix a problem only if you recognize and diagnose it correctly. Ask yourself whether there are things that you do not want to know. When the problem is that you don’t know the answer, but no one else does either, accept that. Set out in search of questions you can answer. People who can’t handle the truth should let someone else manage their money.

Highly Overconfident

Investment institutions are rife with overconfidence that their answer is right. Wall Street is a magnet for alpha males and people born on third base who think they’ve hit a triple. Seriously, being cocksure helps careers. In fields where ability is easily measured, self-assurance and skill usually go hand-in-hand. Attempts to detect investing skill are thrown off by noise and streakiness, but clients still flock to a coherent story, told confidently. Overconfidence might even be rational, in that economic man fearlessly takes any risks that will maximize wealth. Chickens like me won’t take risks unless we’re paid. From the cheap seats, it looks like some triumphant, bold risk-takers were just lucky.

Confidence becomes overconfidence when you seriously miscalculate the odds and take risks that leave you uncomfortable. To believe that your analysis is right and the market wrong, you need confidence, which, without a valid reason, is arrogance. You should be confident in proportion to your own skill, knowledge, consistency, and patience, even if that’s not the signal that the market is giving you today. It also helps to know the boundaries of your knowledge and skill. I am more confident with stocks than bonds, for example, and the long term over the short term. Be wary of topics at the edge of your expertise (like, for me, the nuances of psychology).

Decisions can also be affected by whether trade-offs are framed as losses or gains. For example, framed as a recurring, certain loss of a premium, no one would buy insurance. Instead, it’s sold as gaining certainty that policyholders will not suffer from a catastrophic loss. When something is presented as a gain, people usually choose the guaranteed or safer option. When presented as a loss, they pick the riskier option, which in this case would be going uninsured for a devastating event. Investing is all about trade-offs between risk and return, and among diverse risks, such as fiduciary dishonesty, mismanagement, obsolescence, and financial failure. Unless you really are getting something for nothing, comparisons shouldn’t be framed as losses or gains, but as trade-offs.

Recognize Mistakes Quickly

Investors are often said to be myopically loss averse because they are quicker to sell to take profits than they are to recognize losses. They are pulling the flowers and watering the weeds. However, if the intrinsic value of a stock is unchanged, it isn’t a mistake to hold a fallen stock. I might even buy more. It is a mistake to anchor on an old value when the situation has deteriorated severely and the stock is now overpriced. It’s also a mistake to sell if the stock’s value has surged faster than the price. Be quick to recognize mistakes, not necessarily losses.

Profit from Mistakes of Others

Given all of these oh-so-human frailties, some argue that rules-based investing by the numbers is the solution. I don’t fully agree. Algorithms, bots, and screens do take the emotion out of investing. Increasingly used by quantitative investors (“quants”), these tools often function like idiot savants, doing complex things extraordinarily well while making a mess of simple tasks. For example, “flash crashes” have caused prices to briefly plunge to levels far below any commonsense estimate of value.

System 1 reflects our species’ hardwired wisdom from earlier times and makes simple tasks simple—for humans. I worry that quants forget that stocks are not just numbers but part ownership of businesses, run by people. For now, I think humans are better at gauging whom to trust and visualizing how societies, institutions, and technology might interact and evolve. My ideal is Spock: half human, half Vulcan.

One last run at rescuing (rational) economic man: The stock market charges us for certain emotions and behaviors, and pays us for others. Consumers pay money to buy goods and services that make them feel a certain way. Even for ridiculous purchases, like Vegas gambling sprees, the consumer is said to be king. If investors can select stocks that make them feel the same way, shouldn’t they be willing to give up an equivalent amount of money to do so? With volatile glamour stocks, you get the same kick as a trip to Vegas, and your losses are tax deductible. Investors often don’t realize that there is a hidden cost for everything that normal persons desire: action, excitement, fun, comfort, social acceptance, popularity, and social exclusivity. There’s also shadow income from patience, boredom, worry, courage, pain, loneliness, being a nerd, and looking like an idiot.

The most expensive emotions are seeking comfort and panic, which induce unplanned purchases and sales. “Oh crap, how could I lose half my money in a conservative stock? The doommongers were right. I must destroy the evidence now.” Followed by, “I was right to panic, and can’t go back.” Hanging out with the celebrity stocks is snazzy fun while it lasts. Conversely, value investors worry that the market might be right and that the situation may truly be pitch black when we think it’s overcast gray. When our facts prove out, being a nerd can be quite rewarding.

While I believe that patient people make better decisions than hyperactive thrill-seekers, taxes guarantee that even if they hold the same stocks, patience will win. Commissions and fees accentuate this, but ignore them for now. Consider four investors, all of whom face tax rates of 35 percent on short-term trades and 15 percent on holdings of a year or longer. They all buy the same stock, which appreciates 8 percent every year, compounded, and doesn’t pay a dividend. The only difference is how often the investors sell their stock and immediately buy it back. One does it every six months; the others do it at intervals of one, ten, and thirty years. Over thirty years, the lethargic trader accumulates almost twice the value of the frequent trader (table 2.1).

Table 2.1

Effect of Taxes on Thirty-Year Compound Return

	Trade every:
	6 Months	1 Year	10 Years	30 Years
Pretax Return	8.0%	8.0%	8.0%	8.0%
$1,000 Compounds to	$4,576	$7,197	$7,822	$8,703
After Tax Return	5.2%	6.8%	7.1%	7.5%

Note: The tax rate for stocks held less than one year is 35%; long-term holdings are taxed at 15%.

It’s easier to be patient with boring stocks. When I’m paid for accepting boredom, they are among my favorites. Stable, low-volatility stocks have historically done better than theory would predict, and exciting, risky stocks have fared worse. In theory, investors are paid for accepting volatility, but historical returns suggest that risk may actually be an amenity for some speculators. Constant motion is fun, especially when it’s upward. If you could exactly time when a bull market would start and end, you would want the shares with the maximum possible beta (a measure of relative volatility).

I doubt the intermediate future will be like the past for stable, boring stocks. Quants, having noted that low-volatility (“low-vol”) stocks have done well, now are marketing portfolios based on the low-vol “factor,” pushing up their prices. The factor worked before because historically this class of stocks was undervalued. The other reason for the popularity of low-vol is that savers who normally put cash in their savings account or money market fund now earn almost nothing. To earn income, they must invest in stocks but wish they could regain the stable value of a savings account. Barring a crash, I’d expect returns on low-vol shares to support the theory that investors should be paid more for taking risk.

Social acceptance is perhaps the most universal comfort. Of all the motivations of those who make millions they don’t need, social acceptance, popularity, and respect are surely near the top. Some firms are more accepted, popular, and respected than others, and this reflects on their owners. Shares of the most popular and respected companies tend to sell at higher valuation multiples than others, and historically, expensive stocks have underperformed on the market. Usually, businesses are popular and respected because they, and their stock, have done very well. But having set a very high bar, many can’t keep it up, and for them, the penalty is steep.

It’s uncomfortable, but investors do much better with shares that are temporarily in the doghouse. Stocks that aren’t popular, respected, or even socially acceptable usually sell at depressed prices. In the 1980s and 1990s, cigarette stocks were shunned as selling socially unacceptable, noxious products that kill. Even though earnings were compounding rapidly, for decades tobacco stocks had sold at discounted P/Es compared to the overall stock market (with only brief exceptions as in 1972–1973). Since then, even though smoking remains a health hazard, and fewer cigarettes are sold every year, the stocks have beaten the market hugely over time, and their P/Es have expanded.

Almost by definition, the biggest mispricing will involve a glaring, hideous defect that popular opinion thinks cannot be overcome. That’s when your lonely, preferably well-researched conclusion that it either can be resolved, or isn’t so bad, will be rewarded. In principle, we would always buy understandable, well-run, durable franchises at bargain prices, but in practice the market must think that some element is missing. On average, you are paid for being a nerd and sorting out the true situation. Even more, you are rewarded for the courage to act on an unpopular opinion that made you look like an idiot, provided it turns out to be correct. Before then, there’s endless pain and worry that, indeed, the crowd is right.

Are you are willing to do the digging and endure the pain, loneliness, and worry that go with superior returns? Economic man is willing, but many are not. Personally, I tolerate boredom well but am not eager to take pain. If it all seems too much for you, your best options are to invest in an index fund or a low-cost fund in a well-resourced fund complex whose managers take a long-term horizon. Even then, your impatient trading may destroy the benefit of your manager’s patience.

About economists: Their goofy, surreal psychological assumptions are coded advice. Invest where you have an edge through superior information. Consider the popular interpretation, but also variant perspectives. Estimate the value of stocks; don’t trade for other reasons. Try to look out as far into the future as possible. Be (calculatingly) bold. Minimize taxes, fees, and transaction costs; this is done most easily by trading infrequently. Above all, don’t underestimate your rivals. If you are average, don’t count on superior results. The perfect-competition assumption—that in competitive markets firms earn only a fair profit—means go where competition isn’t.

Psychologists advise that you broaden your horizons beyond the easily available information to include social context, historical statistics, and some notion of baseline and normal. Be skeptical if you think you’ve fallen for the narrative fallacy. To correct a misplaced data anchor, use the outside view. Focus on what a stock is worth today. Counteract confirmation bias by seeking refuting evidence and asking whether the opposite thesis is also true. Frame trade-offs as trade-offs, not as losses or gains. Think for yourself.

The aim of mindful decisions is to ensure that things that matter are never slaves to the trivial. By widening your perspective and reflecting, you can avoid unforced errors and being backed into tough choices. Separate the idea from the person, and let ideas fight, not people.