Part 1 of this article identified some general types of bias that can have a significant impact on decision-making. This Part 2 of the article will look more specifically at how biases can affect decision-making in the area of investments.
Market and Investment Dynamic Biases
While some investment decisions are made on impulse, most investments involving a significant amount of money are the product of a deliberative process based on different types of theories about market dynamics and investment opportunities or risks. These theories in turn are often based on perspectives or sources of information that can contain multiple types of bias.
● Overweighting Personal Experience. One type of bias occurs when a person generalizes from or excessively weights his own experiences or surroundings as a framework for understanding reality or predicting future events. If one successfully invests in a restaurant, one might assume that all restaurant investments are good. Similarly, if one invests in a restaurant and it fails, one can mistakenly come to the opposite conclusion.
These types of generalizations can be particularly misleading when one assumes that an investment experience in one market will apply in a different market. An investment strategy that works well in the United States, for example, may for many reasons including market, regulatory and cultural factors, be highly unlikely to work in Vietnam.
● The Expert Friend. Investment decisions can be made, not because they are based on our own experience or analysis, but due to the advice of a friend or friend of a friend who “knows about investing”, “can see around corners”, “has important contacts” or “has come up with a whole new theory about how markets work.”
While friends and friends of friends may be economic and investment geniuses or otherwise have useful perspectives to share, the reality is that people who present themselves or who are presented as investment experts may not be qualified to provide investment advice. Moreover, even if they have solid investing credentials and experience, their advice may not be applicable to our own investment priorities or the current market situation.
● The Financial Press and Information Outliers. Some investment ideas come from reading the newspapers and seeing stories about successful or unsuccessful investments. It can be very easy to see these reports as representing broad market realities. Setting aside the large issue of the accuracy of what is reported in the press, the fact is that news articles reflect a tiny fraction of investment reality.
Since the objective of the news is to look for information that is “newsworthy,” this by definition creates a bias for seeking information that is unique or out of the ordinary.
But while the failure of a restaurant that was started by a movie star may get a lot of press, what is far more useful for someone considering a restaurant sector investment is the unglamorous details of traffic patterns near the proposed site of the restaurant, rent levels, the cost of food items and how stable those costs are, pricing points, cooking processes, table rotation times and marketing strategy.
While some investors such as options traders look to profit from improbable events, the majority of investment success and failure turns on the common place economic facts of everyday life.
● Academic Articles. Other people will build investment strategies based on academic theories about markets. These theories can seem very persuasive because they are found in prestigious journals, are backed up by numerous supporting footnotes and contain impressive looking mathematical formulas. All of these factors in combination can create an aura of objectivity and special knowledge.
The quality of the thinking and the research which produces articles can of course run the gamut of levels of originality and analytical rigor, but it is important to always keep in mind the fact that insights that hold together very well at the theoretical level may not work well in practice. A very good rule of thumb to keep in mind is that markets do not read academic journals and many investment realities run counter to what should happen in theory.
A good rule of thumb to keep in mind is that markets do not read academic journals and many investment realities run counter to what should happen in theory.
Specific Theories About Markets
Apart from general theories about how markets work, investors can also have many biases about specific market factors.
● Favored Part of the Investment Cycle. Some people make investment decisions based on their views of the attractiveness of different parts of the investment cycle. For example, there are people as a matter of investment policy who take the view that it is best to “get in on the ground floor” and others who take the view that it best to invest once there is “proof of concept.”
The problem with both of these statements as guides to investment decision-making is that they do not equate risk and return. If you are not being adequately compensated for ground floor risk there can be very little benefit to participating in an early part of an investment cycle.
Similarly, if you are being asked to pay a very high investment entry price for the fact that a business model has been “proven” and “risk has been taken out of the equation” from a risk and return basis the investment may make little financial sense.
● The Favored Investment Class. Another bias that some people have is with respect to the performance of certain types of investment classes. For example, some people may take the view that “real estate always goes up in value”, “stocks always increase in value” or food sector investments are good because “people need to eat.”
While these types of fortune cook phrases are easy to remember, the reality is that real estate and stocks are assets like any other and their value depends on a number of factors, including most importantly the relationship between how they are valued and the prices that people are willing or able to pay for them. These assets can fall as well as rise in value.
Similarly, it is of course an unassailable truth that “people need to eat” but this biological necessity does not mean that all food sector investments will be successful.
● The Favored Investment Fashion. Another bias trap that it is easy to fall into is to equate investment success probability with things that “sound” attractive, fashionable, profitable or consistent with the values of a particular social set.
For example an opportunity to invest in a boutique clothing store on Champs Elysee may “sound” a lot more attractive to some than investing in inner-city parking spaces and be a better conversation starter at some social gatherings but the parking lot opportunity may turn out to be a much stronger investment opportunity.
A variant of this bias is to assume that “technology is the wave of the future” and therefore “all technology investments must be good.” While tech-based investments can be highly scalable and thus offer upside that is simply not possible in certain other asset classes, the reality is that many types of technology business plans have very little chance of being implemented. Investments are not beauty shows or popularity contests.
● The Favored Performance Metric. Some investors become attached to different types of performance metrics without looking carefully at broader value creation or risk considerations. To take one example, some people take the view that “cash is king.”
While there can be great value in liquidity, it makes little financial sense in many situations to have large amount of cash when a balanced investment portfolio can provide better and more diversified returns and sufficient levels of liquidity.
Another phrase that I have recently heard with regard to categorizing investment opportunity is “its all about cash flows.” Well, no. What matters is the relationship between what is costs to generate the cash flows compared to the value that the cash flows are generating. If you are paying 12% interest on a loan to invest in something which is generating cash flows that provide a return of 10% you are systematically losing money. Rather than cash, cash flows or any other rule of thumb performance metric what is most important is the creation of economic value.
● The Favored Balance Sheet Position. Some investors draw specific conclusions regarding the relationship between the structure of a balance sheet and investment strength. For example, some people come to the conclusion that “leverage is great” or “debt is bad.”
Neither of these statements, from a financial perspective, are useful. Leverage can be useful when investment returns are higher than interest payments and of course interest payments can be made. Debt can create significant risk due to consequences of default but can be a powerful way to more effectively spread equity capital over multiple investments or many types of the same investment.
Conclusion
There are many types of bias that can affect decision making. In the third part of this article we will look at bias issues in investment selection and analysis.
The photo for this article was taken from Unsplash. The photographer is David Clode.