The worst behavioral bias – jumping to conclusions

Investment psychology

Never trust first impressions

Have you ever realized that many of your “judgments and decisions are guided directly by feelings of liking and disliking, with little deliberation or reasoning.” (Kahneman, Thinking Fast and Slow, 2011) p.12. If you think for a moment, you will realize that this is not only true but also explains in large part why we jump to conclusions.

It’s best to look at this problem using examples. Once we have a good handle on the problem we can look at how we deal with it.

Love Tesla cars, bought the stock

The way Kahneman explains it, the question of whether to invest in Tesla stock (in the book he uses the example of Ford) is a difficult one, “but the answer to an easier and related question (do I like [Tesla] cars?) came readily to his mind and determined his choice.” I like Elon Musk. I like the idea of electric cars. Must be a good investment.

And this is the way our mind works. We use a shortcut and don’t realize we have. Once we like the product we start seeing and reading good things about the company. We are then lulled into not doing proper homework before investing.

Kahneman tells us that the shortcut “sometimes works fairly well and sometimes leads to serious errors.” (Kahneman, 2011)p.98. It’s called the Affect Heuristic.

First impressions

Let’s say a friend or pundit online talks about a stock in glowing terms. The company is described really good both as to the underlying business of the company and its finances. You are impressed. The way Kahneman puts it: “…evidence accumulates gradually and the interpretation is shaped by the emotion attached to the first impression.” (Kahneman, 2011)p.82.

Evidence that supports the first impression is noted and evidence that casts doubt on it is ignored. The problem is that we often don’t realize the shaky basis for the first impression and we don’t realize the impact. We don’t see the need to investigate further. We fail to do proper due diligence.

Ignoring base rates

How often have we heard stories about small companies with promising futures? What a concept! This is new! If it takes off, think of the addressable market. Could generate sales in the billions in ten years.

We might jump to the conclusion that this is worth a flier. And, of course, we have to invest enough that if it works out we will make a ton of money. So what if the company has no sales and little more than a business plan. Our mistake is to ignore the rate of failure amongst companies like this. Do we really know this company is different?

Benefit to society of ESG investing

I have nothing against ESG investing but we must be alert to the danger of concluding that since solar power is good for society the company that makes solar panels must be a good company. The investor will tend to see the upside of such an investment and overlook downside risks. And fail to do proper due diligence.

Familiarity and home bias

Many investors feel more comfortable investing in stocks from their home province or state or region. Many limit their investing to their home country. We can develop an illusion that it is somehow safer to invest close to home.

This illusion can carry over into our assessment of the investment merits of the company and can result in reduced vigilance. That is, we have jumped to the conclusion that it is safer and better to invest at home. Home bias can mean the investor overlooks opportunities for diversification. Familiarity and home bias are also examples of the Affect Heuristic.

Yesterday’s companies

In its own way, investing in yesterday’s companies is just a bad as investing in the next big thing or concept stocks.

With globalization, the advance of technology and changes in society, the world, including the investing landscape, is in constant flux. Investing in buggy whips and latterly in film cameras and now oil is not a recipe for success.

The problem is that many investors are not comfortable with change. They have a mindset to invest in businesses that represent the status quo. It’s really a bias to the status quo. In effect they have reached a conclusion about change without realizing it.

Concept stocks

And some investors love change; sometimes to their detriment. Investors love a story. It’s the next big thing. The product is described in glowing terms. The ‘addressable’ market is huge. All the product has to do is capture one per cent of the market and the company will make a fortune and all its shareholders will be rich. But, it’s all a story. And that’s the problem. We are lulled by stories.

Kahneman writes: “The most coherent stories are not necessarily the most probable, but they are plausible, and the notions of coherence, plausibility, and probability are easily confused by the unwary.” (Kahneman, 2011)p.159.

WYSIATI – what you see is all there is

The investor has reviewed an analyst’s report commenting on the strong quarterly earnings the company has just reported. The analyst has upgraded his Target Price for the stock. Without so much as a glance at the company’s balance sheet and other financial statements, a purchase decision is made. The investor did not seem to realize just how little information they had to make an investment decision. They depended utterly on the enthusiastic opinion of one analyst.

What many investors fail to recognize is the extent to which opinions in the reports are based on assumptions that may or not be valid and on estimates, projections and predictions about the future.

The investor has jumped to the conclusion the stock is a good investment. “They did not seem to realize how little information they had.” (Kahneman, 2011)p.88 That’s just the way our minds work.

Conclusion

To avoid the danger of jumping to conclusions we need what Daniel Kahneman calls ‘risk policies’. I call them gap-to-edge rules meaning that by using them faithfully they can help you to avoid the behavioral gap and develop a behavioral edge.

Gap-to-edge rules for this post:

Gap-to-edge rule: Never trust first impressions.

This applies to positive impressions. It doesn’t necessarily apply to negative impressions. A positive impression is the stock you like because you like their cameras, like their restaurant meals, like the cars, etc. Negative impressions are a wariness about a stock for some reason you can’t put your finger on. You can largely trust those.

Gap-to-edge rule: Develop a critical, even cynical, mind-set

Gap-to-edge rule: Be especially wary of any stock where you like the product or service.

Gap-to-edge rule: Be especially wary of hot stocks and companies promoted on the basis of a huge addressable market.

Gap-to-edge rule: Be wary of stocks recommended to you by a friend or person thought to be knowledgeable.

Gap-to-edge rule: Be wary of stocks whose success in the long run depends on the maintenance of the status quo.

Gap-to-edge rule: Be wary of all written material.

We suffer from misplaced confidence in written reports, misplaced confidence in predictions and in planning our investing we make over optimistic assumptions.

Gap-to-edge rule: Never buy shares in any company without doing your homework.

This is a catch all. We need to avoid buying based on little or no real analysis. As John Templeton says in his Maxim 2: “Achieving a good record takes much study and work, and is a lot harder than most people think.”

Gap-to-edge rule: Give yourself time between the decision to buy and placing the order.

This is the time for sober second thought. My habit is to place orders online only one day of the week, Saturdays. This gives me a chance to reflect over Sunday. The orders are actually executed on Monday morning.

Other posts on investment psychology

This post is part of a series. Readers are invited to read Investment psychology explainer for Mr. Market – introduction This will give you a better understanding of some of the terms and ideas and give you links to other posts in the series.

Want to dig deeper into the principles behind successful investing?

Click here for the Motherlode – introduction

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