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Weekly Update (11-27 : 12-04): Overcoming Unconscious Bias
· Warren Buffett famously said that investing was not a game of high intelligence, but more like a master-class in managing one’s own behaviors. “If your IQ is 160, you should just give 30 points to somebody else, because you don’t need a lot of brains to be in this business. What you do need is emotional stability. You have to be able to think independently.”
· Some of the most common emotional biases that attack the nerves (and brains) of investors on a daily basis include, but are not limited to, Hindsight Bias, Confirmation Bias, Anchoring Bias, Representativeness Bias, Availability Bias, Overconfidence/ Underconfidence Bias.
· There are many more types of bias for investors to consider, but the above are cited by the CFA Institute in their curriculum, and anecdotally, we’ve found them to be prevalent among investors.
· Availability Bias is what we experience when we watch the news and listen to Mike Wilson (Morgan Stanley CIO) or Ray Dalio types, speak confidently about their dire forecasts for the future. Because this information is highly available any time we watch TV, it might move up the totem-pole of importance simply because it is more easily accessible – but that does not mean we should prescribe an outsize weighting to what they say as it relates to our specific investment plans. Remember, nobody who goes on the news doesn’t have an agenda. Ray Dalio is the owner of a multi-hundred billion dollar hedge fund. He gets paid on the size and performance of the fund. Folks will give him more money when they perceive there to be more dysfunction or fear out in the world.
· Hindsight Bias is the idea that the past was always obvious and easy to predict in real-time, now that we have the benefit of knowing what actually occurred. A good example of this might be the COVID-19 pandemic. The market drew down rapidly and recovered just as rapidly. Many famous economists and money managers make it seem obvious that the market would recover, as vaccines eventually came out (which they cite as the reason for the recovery.) However, it would be impossible to disentangle whether the causation of that recovery was the scientific ingenuity and hopefulness that we would overcome the disease, or the trillions of dollars of rescue money that the Fed printed in hope that the economy would recover. Hindsight bias gives investors a false sense of security in their own ability to predict the future, when in reality, predictions aren’t worth much, not nearly as much as a good process or system for dealing with reality and markets as they have proven to be at the present time.
· Anchoring Bias is another type of bias that is constantly perpetuated in the financial news. The most common way we see it circulated is when Strategists make bold proclamations like, “the market is undervalued or overvalued based on X, Y, or Z metric.” These metrics are often price-to-earnings ratios. The anchoring often happens on two levels. First, an “average Price-to-Earnings” can be gathered and assessed for the broad market. And that average price to earnings serves as the anchor. If any stock is cheaper or more expensive than average, a pundit will claim that as evidence to buy it or not buy it, regardless of whether the attributes such a stock may hold could merit a premium or discounted valuation to the average stock market valuation. This error also manifests itself when pundits claim as evidence that a broad index average at a point in time is trading above or below a 5 or 10 year average, argues for the index’s cheapness or expensiveness. While this version of the cognitive anchoring bias correctly compares apples to apples (index to index) – it fails to take into account other time-varying factors such as interest rates or point-in-time index constituents (being different at different time periods), which may affect stock market valuations. In other words, it is highly difficult to say with any degree of certainty, which current stock market multiple is “fair,” given the vast number of factors at play.
· Confirmation Bias is one that we have seen become amplified in recent years due to the herding and clustering mentalities that are brought on and exacerbated by social media. Human beings are tribal by nature, and it is in our DNA to seek out similar, like-minded thought leaders, and then attach ourselves to them. With the recent zeitgeist of populist leaders around the world, this is becoming more and more widespread. However, it is particularly acute as it relates to financial analysis and markets because many analysts and strategists wind up simply parroting back information from a select sub-set of investors whom they closely align with. In other words, instead of starting with the broadest universe of pure, unadulterated facts, and basing conclusions upon the preponderance of evidence, investors take a heuristic approach and outsource their thinking to one tribe, one investor, or one way of thinking, and come up with their conclusion first, only finding the evidence afterward, and seeking out only the evidence that supports those conclusions, rather than seeking out disconfirming evidence as well and weighing all the facts appropriately. Among all the types of bias, this one may be the most insidious because it can lead to bubbles/crashes, and non-independent group thinking.
· Representativeness Bias is present in the financial industry when investors assign a set of probabilities to a future event, based on a set of conditions in the past, or a historical analog, that might closely resemble our present situation. Ray Dalio describes this as closely following history to the point where any event in the future becomes “another one of those.” The danger of this thinking is probably self-evident, but it is present in our everyday lives, and certainly in investing. A famous example of this might be the classic comparison in the market of Alibaba to Amazon. Jack Ma famously modeled his company after Amazon, and investors flocked to the company. However, believing in Alibaba to the same degree as Amazon, one is not only betting on the e-commerce business model superiority (an argument which held water), but is also betting on the proposition that the political regime in China is remotely as accommodative as the lax regulatory authorities (at least on monopoly issues) have been in the United States. In other words, viewing something “as another one of those,” is always a highly risky proposition, and one always has to consider the entire slate of facts before making an investment decision.
· Finally, there are errors caused by Biases in Confidence. In other words, being either over or underconfident can hurt somebody. This was particularly evident at the end of 2022, and is evident especially in inexperienced investors. The willingness to extrapolate into the future, events of the recent past, is rarely a formula for success. In this case, most market practitioners were calling for a dire 2023 in the stock market, based on how bad 2022 was. In fact, rather than extrapolate from the recent past, a full examination of the wide range of market outcomes which had occurred during similar periods in the past, led our team at Marathon to conclude that rather than 2023 being a dire year for stocks, it was much more likely to be a very good year in the stock market with 20% + type of returns. In this case, the Underconfidence bias could have been so extreme as to cause unwitting investors to sell and go to cash at the wrong moment. And of course, the Bias can cut the other way too. Strong returns can cause investors to believe that markets will go up every year.
· At Marathon, our portfolios are constructed largely in a regime-agnostic manner, using evidence-based approaches, without trying to time cycles or tactically go to cash. We believe there are academically-linked risk premia that pay investors to have exposure to them, and it is only by continuously acting to remove the weakest stocks that we will realize great results over a full business-cycle. As part of our engrained process, we seek out disconfirming information from the likes of Ray Dalio and Mike Wilson, because, even though we may not agree with everything they say, it is important to understand the opposite, informed, perspective, which at times, may hold merit.
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