Investing is Tricksy

"Many people cling to flawed intuitive models to explain how or why events occur. For example, if a coin is tossed six times and its result – heads (H) or tails (T) – is recorded, the outcomes T-T-HT-H-H and T-T-T-H-H-H are equally probable.

However, many people believe the first pattern is more likely to occur. To them, it just seems more probable. They may have no evidence to support this belief. It just feels right. Some will attempt to find a repeating or causal pattern in the second series, even though there is no real reason to believe one exists.

This type of cognitive error—seeing a pattern or predictability in random events—is so common and so imbedded in stock market analysis that we practically take it for granted. For instance, market analysts are notorious for projecting historical trends too far into the future. They project sales, earnings, stock prices, and many other statistics for years or decades despite evidence that these quantities are inherently difficult to predict.

In addition, a study shows Wall Street analysts have strong financial incentives to be overly optimistic. Research by Harrison Hong, an associate professor at Stanford Business School, and Jeffrey Kubik of Syracuse University found that analysts who deliver optimistic earnings forecasts (not necessarily accurate forecasts) are more likely to be promoted.

Results of the professors’ study, titled “Analyzing the Analysts: Career Concerns and Biased Earnings Forecasts,” were reported in The Financial Times in February 2002. In predicting the future growth of rapidly expanding companies, their expectations are often tied to the recent past even though growth rates usually revert toward an average.

In most cases, there is no real evidence that extending the past trend will be any more accurate than predicting in accordance with broad averages, and yet investors act on extrapolations as if they were probable events. Such “faulty intuition” can set the stage for overconfidence and subsequent overreaction. For example, an inaccurate model of a company’s business prospects can cause portfolio managers to believe double digit earnings growth will continue for decades, even though such cases are extremely rare. The Internet stock bubble in the late ‘90s was a good example.

Overconfidence in intuitive models can also cause investors to miss opportunities. For example, an incorrect model might lead to the belief that a poor-performing business will never recover, causing invest ors to miss a good buying opportunity. In the late 1970s and early 1980s, expectations of continued “stagflation” led to a general negative overreaction on the part of equity investors. The resulting low stock prices prompted Business Week magazine to proclaim the “Death of Equities” in a cover story published in August 1982. As it turned out, this date coincided with the beginning of the greatest bull market in the history of U.S. stocks.

Value investors recognize tendencies such as “faulty intuition” and establish pre-determined processes based on objective analysis rather than personal preference or out-of-context judgments to guide their investment decisions."