Anchoring and Hindsight Biases

We might briefly look a two other systematic biases that are relevant to the investment scene and tend to fix investment errors firmly in place. They are also difficult to correct, since they reinforce the others. The first is known as anchoring,-- another simplifying heuristic. In a complex situation, such as the marketplace, we will choose some natural starting point, such as a stocks current price, as a first cut at its value, and will make adjustments from there. The adjustments are typically insufficient. Thus, an investor in 1997 might have thought a price of $91 was too high for Cascade Communications, a leader in PC networking, and that $80 was more appropriate. But Cascade Communications was grossly overvalued at $91 and dropped to $22 before recovering modestly.

Again, the best defense against this bias appears to be in our earlier mle: If the retums are particularly high or low, they are probably abnormal.

The final bias is interesting. In looking back at past mistakes, researchers have found, people believe that each error could have been

and again, we toss aside our long-term valuation guidelines because of the spectacular performance of seemingly sure winners. As psychologists have pointed out, this bias is tenacious.

A moments reflection shows that this judgmental bias reinforces the others. Recent and salient events, whether positive or negative, strongly influence judgments of the future. People, it appears, become prisoners of such experience and view the future as an extension of the immediate past. The more memorable the circumstances, the more they are expected to persist, no matter how out-of-line with prior norms.

The defense here, as in Rule 26, is to keep your eye on the long-term. While there is certainly no assured way to put recent or memorable experiences into absolute perspective, it might be helpful during periods of extreme pessimism or optimism to wander back to your library. If the market is tanking, reread the financial periodicals from the last major break. If you can, pick up The Wall Street Journal, tum to the market section, and read the wailing and sighing of expert after expert in August and September of 1990, just before the market began one of its sharpest recoveries. Similarly, when we have another speculative market, it would not be a bad idea to check the Joumal again and read the comments made during the 1979 to 1983 or 1991 to 1998 bubbles. While rereading the daily press is not an elixir, I think it will help.

Decisional Biases and Market Fashions

Chapter 16 will detail the seductiveness of current market fashions, how pmdent investors could be swept away by the lure of huge profits in mania after mania through the cenmries. Now, with some knowledge of decisional biases, we can understand why the tug of fashion has always been so persistent and so influential on both the market population and the expert opinion of the day.

Whatever the fashion, the experts could demonstrate that the performance of a given investment was statistically superior to other less-favored ones in the immediate past, and sometimes stayed that way for fairly long periods.

Tulip bulbs appreciated sharply for seven years until 1637. A Dutch expert in that year could easily show that for more than a decade tulips had retumed considerably more than buildings, shops, or farms. The recent record was exciting, and rising prices seemed to justify more of the same.

The pattem continually repeats itself. A buyer of canal bonds in the 1830s or blue-chip stocks in 1929 could argue that though the instmments were dear, each had been a vastly superior holding in the recent past. Along with the 1929 Crash and the Depression came a decade-and-a-half passion for govemment bonds at near-zero interest rates.

Investing in good-grade common stocks again came into vogue in the 1950s and 1960s. By the end of the decade, the superior record of stocks through the postwar era had put investing in bonds in disrepute. Institutional Investor, a magazine exceptionally adept at catching the prevail-

seen much more clearly, if only they hadnt been wearing dark or rose-colored glasses. The inevitability of what happened seems obvious in retrospect. Hindsight bias seriously impairs proper assessment of past errors and significantly limits what can be leamed from experience.

I remember lunching with a number of money managers in 1991. They were bullish on the market, which was moving up strongly at the time. One manager, looking at the upsurge of financial stocks from the depressed levels of 1990, asked rhetorically, "How could we not have bought the financial stocks then?" In 1988, he asked the same question about other ultracheap companies after the much more damaging 1987 crash. Hell likely ask it again after the next major surge.

This bias too is difficult to handle. That walk to the library may be as good a solution as any. I think you will see that the mistakes were far less obvious than they appear today.

ing trends, presented a dinosaur on tiie cover of its February 1969 issue with the caption, "Can the Bond Market Survive?" The article continued: "In the long run, the public market for straight debt might become obsolete."

The accumulation of stocks occurred just as their rates of retum were beginning to decrease. Bonds immediately went on to provide better retums than stocks. Of course, as we know, it happened all over again. In 1982, the greatest bull market of the century for stocks began-naturally at the time institutional funds were stampeding out of equities. As always after a major miscalculation, perceptions shifted radically. Money managers once again tilted shaiply towards stocks, with enormous flows of new moneys pouring into equities in the past decade and a half.

Behind the statistics on expert failure, we saw that the professionals tended to play the fashions of the day, whatever they were. One fund manager, at the height of the two-tier market in 1972/1973, noting the skyrocketing prices of large growth stocks at the time, said that their performance stood out "Hke a beacon in the night." Both the growth stocks and the concept stocks were clobbered shortly thereafter.

Although market history provides convincing testimony about the ephemeral nature of fashion, it has captivated generation after generation of investors. Each fashion has its supporting statistics, the law of small numbers. The fashions are salient and easy to recall and are, of course, confirmed by rising prices-the inputs and outputs again. These biases, all of which interact, make it natural to project the prevailing ti-end well into the future. The common error each time is that, although the ti-end may have lasted for months, even for years, it was not representative and was often far removed from the performance of equities or bonds over longer periods (regression to the mean). In hindsight, we can readily see the errors and wonder why, if they were so obvious, we did not see them earlier.

The heuristic biases, which are all interactive, seem to flourish particularly well in the stock market and to result in a high rate of investor error. We are too apt to look at insufficient information in order to confirm a course of action, we are too inchned to put great emphasis on recent or emotionally compelhng events, and we expect our decisions to be met with quick market confirmation. The more we discuss a course of action and identify with it, the less we believe prior standards are valid. So each trend and fashion looks unique, is identified as such, and inevitably takes its toll. Knowledge that no fashion prevails for long is dismissed.