It is the new year and it is the time for resolutions and forecasting lists. I do not know what it is about lists, but for some reason my likelihood of reading something drastically increases if it is presented in list form! Information presented in a list instantly becomes more interesting and credible.
Now admit it, you are subject to it too. You know that "the 10 facts about Trump he does not want you to know" article suckered you into reading it! Only to find out it did not contain commentary on the picture that compelled you to start clicking on it in the first place. That is ok, you are in good company because we all do it from time to time.
There are actually a number of psychological reasons that compel you to read it. List-style headlines often provide that optimal balance of information and ambivalence, intriguing you just enough to click, on the chance that you will come across something particularly relevant or exciting, according to physiologist Maria Konnikova.
Do not stop reading, though, the list in this article is different!
Behavioral biases in investment decision-making
Our investment success is undermined by biases to a much larger extent than we probably recognize, let alone are willing to admit. For most money managers there are strict guidelines and investment criteria that place guardrails around how the money is invested. An investment mandate, as it usually is called, is commonplace in virtually all funds and investment houses. Even proprietary traders at banks have restrictions put upon them. An investment mandate is supposed to prevent us from doing stupid things and to keep biases from creeping in and wreaking havoc. Having those constraints is what is attributed to traders having success, where they tend to fail when they trade privately in the absence of defined restrictions. Mandates or no, biases invariably creep in, and in the best case you lose a little money, at worst you lose your livelihood or life in the case of famous speculator Jesse Livermore.
One of the best books on the subject is "Extraordinary Popular Delusions and the Madness of Crowds" by Charles Mackay. It describes some of the most staggering examples that have occurred in history, and it illustrates that the learning curve for human behavior is not very steep. Examples date back to the 1600s when the Tulip mania in Holland reached its peak during the winter of 1636, when some bulbs were reportedly changing hands ten times in a day for prices of over 10 times the equivalent of an artisan's annual wage. No deliveries were ever made to fulfil any of these contracts because the tulip bulb contract prices collapsed abruptly and trade came to a halt. The collapse was reportedly triggered when a sailor at a tavern - oblivious to the fact that it was a tulip trading hub - cut into a priceless tulip mistaking it for an onion. It was the unpredictable ah-ha moment that burst the bubble. Just imagine that mania, a tulip trading at the equivalent of 4 Tesla model S cars (assuming average skilled worker of $36k and $90k model S)
As in the case of the Tulip mania, when the delusion becomes apparent, reality sets in and the ensuing price collapse is often magnificent. The main takeaway is that markets or stocks can get out of control (in a positive or a negative direction) because of a predominant bias, or better still, multiple biases. The bias presents a situation where there is an opportunity to make money. The catalyst to the tulip collapse was difficult to identify, let alone predict when it would occur. This is more often the case than not in situations where you suspect the market is out of control, especially if it has been going on for a while. However, if you are on the right side of the trade you can make money - or at minimum - avoiding the trade can prevent you from losing your shirt.
So, here are my top ten biases, in a list. For each bias I have picked a stock that is particularly subject to the bias, and I go so far as to make a call on the stock performing bullish or bearish this year, with a brief subjective rationale.
Stick around because at the end of the article I will present my top pick: the one company that is subject to multiple and the most extreme biases!
1. Anchoring. This is where you let your future decisions be influenced by the information that was available at the time you made the investment. After your initial analysis you purchase a stock. Later you get new information and rather than performing a new analysis, you simply revise your old analysis. Usually, this will manifest itself in fixation on the stock price, either your entry price and/or your intended exit price. Those price points are irrelevant and you should focus the new target price informed by the analysis of the new information, yet you cannot let go of what you think the price should be.
The afflicted: Valeant Pharmaceuticals International, Inc. (VRX)
The forecast: bearish
The rationale: The stock suffered a spectacular collapse, and some high profile investors have stuck with their position and defended it as a good investment. It is far from certain that the current price reflects fair value for this company with $30+ billion in debt. The investors might be justifying their positions by sticking to their original investment thesis anchored to original entry and target exit prices.
2. Story bias. We all like a good story! It turns out a narrative is crucial to how you make sense of reality. It helps you to explain, understand and interact with everything around you. A story gives you a frame of reference that you can use to remember the concepts you think it represents. In short, you prefer the story over the cold hard data. Keeping your analysis and interpretation of the data from being polluted by your pre-conceived notions is extremely difficult, unless you are like the combination of these two:
The company and market participants will craft a story and if believable, folks will invest. Related to this bias is what Nassim Taleb calls the "narrative fallacy" (see also confirmation bias), where you look backward and creating a pattern to fit events and constructing a story that explains what happened along with what caused it to happen. You can see it on a daily basis in the media, where the movement in the market is attributed to a given event. The relationship is not proven, simply assumed - i.e. a story that is made up by the narrator because he/she thinks it is what drove the event.
The afflicted: Alibaba (NYSE: BABA)
The forecast: bearish
The rationale: Alibaba's story is great; Jack Ma, a former English teacher from humble beginnings makes for an unlikely CEO, starts his company in his apartment only to grow it to be the largest e-commerce giant in China. And it's China, the biggest population, stellar economic growth and so forth. Not to mention, it is moving into the cloud! And it has Alipay, the biggest payment network. The counter arguments are that the payment network is no longer (fully) owned by Alibaba shareholders, its reported metrics are overly optimistic, growth is slowing, margin is narrowing, the cloud activities were and are only 2% to 3 % of revenue and unprofitable to boot, it has an unparalleled need for cash to fuel vague and questionable expansion strategies and management enriches itself, to name but a few. Full disclosure, I recently wrote a negative article on Alibaba found here, and some readers accused me of being biased (which admittedly is true - mostly from bias number 7 in this list).
3. Halo effect bias is a cognitive bias in which your overall impression of a person or company influences your assessment and beliefs about that person/company's overall character or properties. The halo effect is a specific type of confirmation bias, wherein positive feelings in one area cause bad traits to be viewed positively. It is also known as representativeness bias. You incorrectly think one thing means something else.
The afflicted: Tesla (NASDAQ:TSLA)
The forecast: bearish
The Rationale: investors like the Tesla cars and therefore think the stock is a good investment. They also like the larger than life CEO who reportedly is brilliant, and had great success with making money with PayPal (NASDAQ:PYPL) and transpose that to Tesla stock, thinking it makes for a good investment.
4. Self-justification bias: this is about cognitive dissonance. Have you ever been in a situation where your actions or behavior were inconsistent with your beliefs and you subsequently justified that behavior and denied any negative feedback associated with the behavior? If you have kids and set the wrong example after telling them just minutes prior not to do that exact thing - like not washing your hands before dinner time, because let us face it your hands are clean, right - you probably know what I am talking about.
The afflicted: Wells Fargo (NYSE:WFC)
The forecast: bearish, then bullish latter half 2017
The rationale: Wells Fargo employees fraudulently opened 1.5 million bank accounts and applied for 565,000 credit cards unbeknownst to the respective customers in order to qualify for bonuses. Management displayed self-justification and ducked and dived responsibility. Much respected investor Warren Buffett was slow to criticize what was seemingly embedded and condoned behavior within a company that he has openly laurelled for being the best bank in America. Finally, under pressure CEO John Stumpf grudgingly took responsibility and stepped down. The new CEO will take a big bath to clean up, causing a near-term slump.
5. Familiarity bias is your predisposition to invest in stocks and industries that you are familiar with. It causes you to be too concentrated in well-known names, usually in your own region. In other words, you feel more confident about stocks you think you know.
The forecast: bullish
The rationale: The multi decade "Malkiel Random walk" and "Bogle low cost index" movement has clustered vast numbers of hands-off and loss-insensitive investors in, known to everyone, big market capitalization American stocks. Automatic investing plans, company 401k matches, target funds, ETFs, trend followers, momentum investors, impulse stock buyers and the like will continue to allocate new money to feed the big-gets-bigger trend. While this may come to a screeching halt with an implosion to match, I am playing the odds that it does not happen anytime soon.
6. Negativity bias. This bias refers to the idea that your unpleasant or painful events and memories have a greater importance over the positive or pleasant events that you have experienced. Not to sound too much like Anthony Robbins, but you will do more to avoid pain than seek pleasure. It is probably an evolutionary thing where long ago your ancestors learned that running away from the attacking lion took precedence over getting frisky with your lover, and as a result your place in the gene pool was ensured.
The afflicted: Sears (SHLD)
The forecast: bearish
The rationale: The stock has been unloved for years because of continuous losses, valuable real estate being sold off, unappealing stores, the need for liquidity lifelines from its CEO and the list goes on. Fewer and fewer investors are left, besides Lampert and Berkowitz. While the bias is probably overdone, there will be at best a stabilization of the stock price.
7. Confirmation bias. You like to think that you collect and evaluate data very carefully before coming to a conclusion. Unfortunately, the odds are that you do not. Instead, you tend to suffer from a bias where you reach a conclusion first. Then you will go out and cherry-pick the data to support your pre-conceived conclusions. It is what makes you chase investment performance, often piling into stock right before its peak. Because the investment has been climbing higher recently, investors believe that will remain the case.
The afflicted: S&P 500 index (NYSEARCA:SPY)
The forecast: initially bullish in '17, bearish after that
The rationale: I realize that I cheated a little bit because this is not a single stock but an index. We are in an eight-year bull stock market, one of the longest in history. The Trump victory unexpectedly added momentum to the market and investors piled in again not wanting to be left out. The effect will wear off and disappointment with the new cabinet will set in as it invariably has done in the past.
8. Recency bias. This is the phenomenon where you remember something that has happened recently more vividly. Because of that you place more importance on it, compared to remembering something that may have occurred a while back, on which you consequently place lower importance or a lower chance of that situation occurring.
The afflicted: Chevron (NYSE:CVX)
The forecast: neutral
The rationale: Chevron has trended upward by about 30% in 2016, aided by a rebound in the oil price, putting the memories of the slump behind us.
9. Wishful thinking bias. This is the bias where there is an overinfluence of a desired outcome on your optimism. Or, in other words, you form beliefs and make decision based on what you think might be pleasing to imagine instead of resorting to evidence or reality. This particular bias is a sub-manifestation of overconfidence bias.
The afflicted: Caterpillar (NYSE:CAT)
The forecast: bearish
The rationale: the new administration is intent on infrastructure spending. Caterpillar is trading at historically high multiples and the expectation of aforementioned spending is fully priced in. The timing of infrastructure spending and the actual actions of the administration will take longer than expected and have the potential to disappoint.
Number 1 stock pick for 2017 with most biases
The list is supposed to be lighthearted and fun. Wait, "fun?" you may ask. We invest to maximize our return. An emotion like fun should not enter the investment equation! If that was your first reaction and you do not identify with a single bias above, nor with the 170+ or so other biases, then there is hope for the efficient market hypothesis!
If that was not your first reaction, hopefully you are not upset about your favorite stock being my bearish pick. If the atmosphere is such that the vast majority of the crowd meets me with anger, ridicule, disdain, or outright dismissal when I bring up a topic - regardless if it is investment related - it is usually the first and foremost indicator that I have stumbled across a case of mass hysteria.
Let me fully acknowledge the forces identified above have negatively affected my judgment to some degree. I objectively examined all the stocks that I know (familiarity), have held this opinion for a while (anchoring), that all the data that I have collected supports my theory (confirmation) and well, a bunch of others, you get the point.
The winner is: Tesla
The forecast: bearish
Yes, I know - how dare I, right? Well, there you go, you just confirmed my number one indicator. Not often do I come across a stock where the investors are so clearly divided. It seems there is no middle ground on this one, you are either a totally committed believer or you think it is a script from a dark comedy movie. Civility goes out the window when the two camps meet. The battleground; articles like this and especially their comment sections.
In the table below I have captured a sample overview of the commonly heard bullish arguments.
Sample overview of biases affecting Tesla stock
|Bias||Bullish motivation||Bear interpretation|
|Anchoring bias||Originally entered stock position because Tesla delivered highly rated car, a break-through product||The bulls have not adjusted their original theses to reflect the fact that growth is slowing, the company is not making any money, has continuously failed to meet targets, continues to move to goal post with new visions of the future and so forth|
|Story bias|| |
Tesla with the recent acquisition of SolarCity is perfectly poised to deliver an integrated, fully self-sufficient, end-to-end green energy solution.
They hold a defensible lead in driverless car technology and will be in pole position to monetize the ride-sharing marketEtc.
The stories are not based on facts
EVs are not as green as the bulls think
Solar tile roofs are not cost efficient and will not generate enough energy to power your residential power needs, let alone charge your EV
There is no defensible proof that Tesla holds the lead in driverless technology, nor is there good visibility to it being available in the near future
EVs are not the likely candidate for capturing the ride sharing marketEtc.
|Halo effect bias||Visionary and billionaire CEO who is a billionaire to boot, with a proven track record with PayPal|| |
Success with PayPal is no guarantee for success in other industries
Just because the billionaire created wealth for himself does not mean that the Tesla investor will flourish along side him (in other words, your money is the reason he is wealthy, not the other way around)
Visions of life on Mars have nothing to do with successfully running an automotive corporationLiking the quality of the car is not a sufficient investment analysis of Tesla the company (for example, it could be a badly run company)
|Self-justification bias||Just because my carbon footprint is off the charts does not mean that I cannot vehemently defend going green with a solar roof and EV||Both investors and the CEO are unbelievable with going green if their actions are inconsistent with it. High income demographic that currently is the predominant customer for uneconomic solar roof and EV purchase behavior come across as disingenuous. Their self-justified defense of supporting the going green movement should not influence Tesla as an investment thesis.|
|Familiarity bias|| |
Tesla is the best way pick to play the sustainable, integrated energy industryTesla is the dominant player in the electric vehicle space
|Just because Tesla is the most recognizable name and is the first mover and currently has the leading position in EV, it is not likely to hold on to that position. Nor is now the best time nor is it the best way to profit from the going green or EV trend.|
|Confirmation bias||Tesla holds the lead in the driverless technology department. It is the first automotive company to put it into practice||Tesla may have been the first to let (portions of) driverless technology loose on consumers but they are also the first to experience consumer deaths as a result. Other companies (Audi, Volvo, Uber, Google, etc.) have been testing/experimenting with the technology for some time and just because they did not release it to consumers, does not mean their technology is lagging.|
|Wishful thinking bias||Tesla will deliver 500,000 model 3 cars a year, it will have the capacity to do so at the end of 2017, it will start making a profit on a per car basis, it will hold on to the lead in driverless car technology|| |
Car industry experts have indicated that the projected ramp-up in production with volume deadlines are not feasibleCurrent and past performance from Tesla does not show the ability to consistently make a profit and there is insufficient data to believe that it will be capable of doing so in the future
Disclosure: I am/we are short CAT, TSLA, BABA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.