Finishing our Bias mini series, we conclude with Incentive Caused bias and Hindsight bias.
Incentive Caused Bias

Incentive caused bias is the power that rewards or incentives can have on human behaviour, often causing folly. The sub-prime housing crisis in the United States is a classic case study in incentive caused bias. Notwithstanding that financiers knew that they were lending money to borrowers with appalling credit histories, and in many cases people with no incomes or jobs and limited assets (“NINJA” loans), an entire industry, with intelligent people, was built on lending to such people.

How did this happen on such a massive scale? We believe the answer can be found in the effect of incentives. At virtually every level of the value chain there were incentives in place to encourage people to participate. The developers had strong incentive to construct new houses, the mortgage brokers had strong incentive to find people to take out mortgages, the investment banks had strong incentive to pay mortgage brokers to originate loans so that they could package and securitise these loans to sell to investors, the ratings agencies had strong incentive to give AAA ratings to mortgage securities in order to generate fees, and banks had strong incentive to buy these AAA rated mortgage securities as they required little capital and produced enormous, leveraged profits.

Warren Buffett said: “Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behaviour akin to that of Cinderella at the ball. They know that overstaying the festivities — that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future — will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.”

One of the key factors in making investment decisions is evaluation of agency risk.  It is important to evaluate the incentives and rewards systems in place to assess whether they are likely to encourage management to make rational long-term decisions. Companies that have incentive schemes that focus management on the downside as well as the upside and encourage management to return excess cash to shareholders tend to perform better in the long-term. For instance, executive compensation that is overly skewed towards share option schemes can encourage behaviour that is contrary to the long-term interests of shareholders, such as retention of earnings above those that can be usefully reinvested into the business.

Hindsight Bias

Hindsight Bias is the tendency to see events that have already occurred as more predictable than they actually were before they took place.  Also described as the “knew it all along” effect, with respect to financial markets, it tends to manifest as a tendency to see past beneficial events as predictable and bad events as not predictable.  For example many failures attributed to the GFC were in fact entirely predictable as credit markets had expanded dramatically in the years leading up to and financial stocks were at all time highs. Money was far too easy and cheap as evidenced by the ever increasing structuring, leveraged buy-outs etc that were occurring.  Accordingly, we had significantly reduced or removed many investments we felt could suffer adversely when credit bubble popped or at least markets normalised.  We held little or no investments in heavily geared or engineered investments such as listed property, structured infrastructure funds, credit market hedge funds, or Collaterised Debts Obligations (CDO).

This relatively easily predictable re-rating of credit however did not readily translate in the predicting the ultimate collapse and subsequent freezing of credit markets, the actual GFC event itself. This was entirely unpredictable and in analysing the rare few who seemed to take action prior to the collapse, we merely find a combination of “extreme event they were willing to bet on, amongst many other bets”, through to just sheer luck.  The fact that someone wins lotto by selecting the right numbers, (a conscious and deliberate act), doesn’t make the selection of those actual numbers a factor in the success. This is simply an example of survivorship bias, selecting numbers is simply a prerequisite to be eligible for a result.

The real danger with hindsight bias is its ability to cloud objectivity in assessing past decisions and hence inhibits the ability to learn from past mistakes.  Just like tossing a coin, some things simply are predictable, regardless if you guess right or wrong, you cannot simply learn from the result and improve your future chance of success.  Trying to do so is distracting at best and extremely dangerous and its worst.  To see this effect in action, simply spend some time observing roulette players at your nearest casino.  The casino helpfully displays recent winning numbers and importantly whether they were red or black.  Eventually one colour will show a significant “overweight”, providing the opportunity for the alternative to be “due”.  No understanding of probability or statistics is needed to understand what’s at play here, simply ask yourself – if it improved your chances or picking a winner, would the casino actually offer this information so freely?  Watch it encourage the players though………

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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