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Part 1 of 5 in out Bias mini series, here we take a look at Cognitive biases, Confirmation biases, and Neglect of probability.

We see and experience biases covered in this series on a daily bases & we find it interesting to note & be aware of in the conduct of our lives.

Cognitive Biases

Behavioural Finance and in particular, cognitive bias one of my favourite topics for two really important reasons:

  • They are hard-wired into us – we all have them, in varying degrees perhaps but we do, even you
  • They are responsible for ALL the decisions we make – yes every single one, whether we want them to be or not.

This however doesn’t mean we’re doomed to make the relevant mistakes, it simply means we need to recognise we have a problem and make sure we take measures to reduce the possible negative impacts these biases can have.

I won’t go into the science at this point as a simple Google search can give you more than real scientific evidence of the existence and possible impact of these behaviours.  In fact there’s now so much research in this area that the collective research is now beginning to show the severity of the “problem” is possible much less than first thought – but that’s for another day.  When it comes to finances, the amount of bias isn’t really the issue; it’s the size of the possible impact that matters.  A major bias with little ultimate financial impact is much better than a small “leaning” which results is a significant adverse financial impact.

Over the coming months I’ll highlight a series of major “Biases” and discuss their relative danger and how we can guard against them.  Now I’m not suggesting we try to “dehumanise” ourselves, making basic mistakes can be a fun way to learn and grow, however I’m sure most of us would prefer to limit our financial mistakes, or at the very least make very informed ones.

Confirmation Bias

Of course I’m starting with this one as it’s by far my favourite.  Not just because it’s almost always present but it’s often a bit involved in other biases as well.

Confirmation bias is the natural human tendency to seek or emphasise information that confirms of an existing idea or belief.  Confirmation bias is a major reason for investment mistakes as people are often overconfident as they keep getting data that appears to confirm the decisions they have made. This overconfidence can result in a false sense that nothing is likely to go wrong which increases the risk of being completely blindsided when something actually does. In order to minimise the risk of confirmation bias we continually attempt to challenge the status quo and seek information that causes us to question our investment beliefs.

In fact, we are always seeking to “invert” the investment case to critically analyse why we might be wrong. We continuously revisit and challenge our assumptions. It is much more important to understand how things would look if you were wrong.  Imagine a world where your beliefs are wrong, if this still looks Ok, then perhaps you’re not so right after all.

Charlie Munger, the Vice Chairman of Berkshire Hathaway and Warren Buffett’s business partner, said: “We all are learning, modifying, or destroying ideas all the time. Rapid destruction of your ideas when the time is right is one of the most valuable qualities you can acquire. You must force yourself to consider arguments on the other side”.

In our view, the strength of many of history’s most accomplished scientists and mathematicians has been their ability to overcome their confirmation bias and to see all sides of a problem. Carl Jacobi, the famous 19th century mathematician, said: “Invert, always invert”.

Neglect of probability

As humans, we tend to completely ignore, or over or underestimate, probability in decision making. Most people are inclined to oversimplify and assume a single point estimate when making investment decisions. The reality is that the outcome an investor has in mind is their best or most probable estimate. Around this outcome is a distribution of possible outcomes, known as the distribution curve. The shape of the distribution curve of possible valuation outcomes can vary dramatically depending on the nature and competitive strength of an individual business. Businesses which are more mature, less subject to economic cycles and have particularly strong competitive positions (examples would include Coca-Cola and Nestlé) tend to have a tighter distribution of valuation outcomes than businesses that are less mature or more subject to economic cycles or are more subject to competitive forces.

It’s important then to distinguish between the different types of businesses to account for the different risks or probabilities of outcomes. Another error investors make is overestimating or mispricing the risk of very low probability events. That does not mean that “black swan events” cannot happen but overcompensating for very low probability events can be costly.

We seek to mitigate the risk of “black swan events” in two distinct ways.  Firstly in overall portfolio construction by maintaining a level of “secure pool” assets (generally cash and fixed interest), to allow the required annual cashflow needs to be met without having to sell growth investments.  Generally around 3 years cashflow is kept in this “secure pool”, which in turn may be topped up with cashflow received from growth investments.  This combination generally means the “secure pool” investment last at least 5-7 years before running out, providing sufficient time for the vast majority or market cycles.  Whilst individual portfolios vary, on average we find most client’s “secure pools” last significantly longer, further reducing the likelihood of any growth assets being sold during “black swan” periods.  If asset values are given time to recover, the long-term impact is minimal.

The second level of “black swan” protection is by including in portfolios, investment managers who focus on the quality of long-term earnings.  These managers tend to focus on buying high quality, long cycle businesses (at appropriate prices), that is businesses where the distribution curve of valuation outcomes is particularly tight.  We believe the risk of a permanent capital loss from a “black swan event” in this part of the portfolio is low as the earnings of such companies tend to be less impacted or recover more quickly.  Given it’s the earnings growth that ultimately drives the value, it’s all about solid long-term earnings growth.

The issue for investors is assessing when the probability of such an event is significantly increasing. It is usually not correlated with the amount of press or market coverage on a particular event. Warren Buffett recently said in an interview (7 May 2012, CNBC): “The worst mistake you can make in stocks is to buy or sell stocks based on current headlines”.  The sad fact is however, the vast majority of buy and sell decisions, particularly by retail investors, are in fact based this way.  They may not be based on one particular headline, more often the “weight” of collective news, but the headlines drive the decision.

For example, it is our view that the risk of a financial Armageddon event due to the European sovereign debt crisis has actually decreased this year primarily due to the liquidity provided to European banks by the ECB last December and again in February this year. Notwithstanding this reduction in risk the financial media has been in near hysteria about the increasing chance of the collapse of the Euro in the near term.

I expect this will subside somewhat over the coming weeks as the Olympics provide a new source of easy headlines.  In fact, I’d be willing to bet “Olympic” related news will significantly outweigh financial news over August.  Obviously this has nothing to do with the relative importance of sport versus finance.  Whilst most Australians tend to regard sport as fairly important, I’m confident money ranks higher for most.

Inspiration and content for this series has been obtained from a number of sources in particular, Wharton Business School, Magellan Asset Management and Platinum Asset Management.
Matt Battye

Matt Battye

CEO, Financial Adviser

Analysing what can seem to be like complex issues, Matt is effective in using analogies to better explain scenarios and truths to the rest of us. This is what Matt enjoys – educating clients on the truths and debunking the commonly held (wrong) view.

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