Part 2 of our Bias mini series, we look at Information bias, and the Bandwagon effect.
Information Bias

Information bias is the tendency to evaluate information even when it is useless in understanding a problem or issue. The key in investing is to see the “wood from the trees” and to carefully evaluate information that is relevant to making a more informed investment decision and to discard (and hopefully ignore) irrelevant information.

We are bombarded with completely useless information every day, from financial commentators, newspapers and stockbrokers, and it is difficult to filter through it to focus on information that is relevant. In our view, daily share price or market movements usually contain no information that is relevant to an investor that is concerned about the medium-term prospects for an investment, yet there are entire news shows and financial columns dedicated to evaluating share price movements on a moment by moment basis.

In many instances people will make investment decisions to buy or sell an investment or change their superannuation funds on the basis of short-term movements in share prices. This can cause people to sell wonderful investments due to the fact that the share price has fallen and to buy into bad investments on the basis that the share price has risen.

Try this for yourself.  Over a period of 1 week, watch the “finance” segment of any major TV station each night.  Take notes on the major “drivers” of the markets that day and relative impact that had.  At the end of the week, have a look back over your notes to see what difference a day makes.  In particular have a look how one day’s apparently important issues, bad enough to wipe billions of dollars of the market, suddenly don’t seem to be even rate a mention the next day, as new “drivers” take over.  It’s also worth taking note of what impact the week actually had on your life.  Given all those movements in oil and copper prices, the Aussie Dollar versus the Euro and those random economic figures that came out this week, how much different is your life now?

In general, people would make superior investment decisions if they completely ignored daily share price movements and focused on the medium-term prospects for the underlying investment and looked at the price in comparison to those prospects. Ignoring daily commentary regarding share prices, foreign exchange rates or commodities prices would overcome a dangerous source of information bias in the investment decision making process.

Bandwagon Effect (or groupthink)

Bandwagon effect, or groupthink, describes gaining comfort in something because many other people do (or believe) the same.  This again is a evolutionary response to social groups.  Whenever we are uncertain how to behave, we seek cues from those around us.  As social animals we have developed a set of “group rules” which help govern our behaviour so as to minimise mistakes in unfamiliar circumstances or avoid upsetting the group.  This why we form queues and dress to a “standard” for social events.  Jumping the queue or dressing too casually will risk resentment or isolation from the crowd and is therefore to be avoided.

Desire to counteract this effect can sometimes lead to the opposite “contrarian for contrarian’s sake” response, ie take note of what the crowd is doing and do the opposite.  Whilst there is certainly many examples where this may even lead to a better result (its often proposed for investing), the reality is this just as flawed – its’ still a bandwagon effect, albeit you do the opposite.  It relies on the crowd to be wrong regularly or significantly and if this really was the case, it’s unlikely we would have developed this mentality in the first place.  The fact is reason we follow the herd is because most of the time it gives us a good result and even when it doesn’t, at least where not alone.

The real challenge then is to determine when to follow the crowd and when not to.  The major mistake we tend to make is we simplify our options to go with or against the herd.  There’s also the option of neither.  The trick is to minimise the times when we need “herd cues’ in the first place.  Given we look for such clues when we don’t know the answer, the solution is to make sure we have our own decision process, external to the herd.

The power of the herd is not to be underestimated however as many good decisions don’t survive contact with the herd. It’s important therefore to only change your mind if the crowd provides new information which, when considered with your previous knowledge, changes your conclusion.  The direction of the crowd is irrelevant.

Warren Buffett tells a story about the oil prospector who dies and is in a large crowd of other oil prospectors who are all waiting at the gates of heaven. All of a sudden the crowd disperses. Saint Peter asks the oil prospector why the crowd dispersed. The oil prospector said it was simple: “I shouted oil discovered in hell.” Saint Peter asks the oil prospector why he would like to be let into heaven. After thinking for a while the oil prospector says, “I think I will go and join my colleagues as there may be some truth in that rumour after all.”

In our view, to be a successful investor, you must be able to analyse and think independently. Speculative bubbles are typically the result of groupthink and herd mentality. We find no comfort in the fact that other people are doing certain things or whether people agree with us. At the end of the day we will be right or wrong because our analysis and judgement is either right or wrong.  Importantly this also allows you to learn from your mistakes. At least when you’re wrong you can look at why and adjust for the future and improve over time.  Following the crowd provides no such mechanism for improvement.

While we don’t seek to be contrarian, we have no hesitation in taking “the road less travelled” if that is what our analysis concludes.  Sure I’ll read the dress code, but I’ll always wear what my wife tells me to regardless.

Inspiration and content for this series has been obtained from a number of sources in particular, 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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