If It Looks Good, It Must Taste Good

There is yet another powerful heuristic bias stemming from representativeness. This is the intuitive belief that inputs and outputs should be closely correlated. We beUeve, in other words, that consistent inputs allow greater predictability than inconsistent ones. Tests have shown, for example, that people are far more confident that a student will regularly have a average if he has two Bs rather than an A and a C, although the belief is not statistically vahd.* Or if the description of a company is very favorable, "a very high profit is most representative of that description," and vice-versa.This fallacy usually leads to consistent errors in the market.

The direct application of this finding is the manner in which investors equate a good stock with a rising price and a poor stock with a falling one. One of the most conunon questions analysts, money managers, or brokers are asked is, "If the stock is so good, why doesnt it go up?" or, "If contrarian strategies are so successful why arent they working now?" The answer, of course, is that the value (the input) is often not recognized in the price (the output) for quite some time. Yet investors demand such immediate, though incorrect, feedback-and can make serious mistakes as a consequence.

Another interesting aspect of this phenomenon is that investors mis-

"case rate"). Long-term returns of stocks (the "base rate") are far more likely to be established again. If returns are particularly high or low, they are likely to be abnormal.

Returns that are extremely high or low should be treated as deviations from long-term norms. The long-term return of the market might be viewed like the average height of men. Just as it is unlikely that abnormally tall men will beget even taller men, it is unlikely that abnormally high retums will follow already high retums. In both cases, the principle of regression to the mean will most probably apply, and the next series of retums will be less extreme.

Because experts in the stock market are no more aware of the principle of regression than anyone else, each sharp price deviation from past norms is explained by a new, spurious theory. This, together with other cognitive biases we will examine, leaves the investor vulnerable to the fashions of the marketplace, however far removed prices may be from intrinsic worth.

RULE 26

Dont expect the strategy you adopt will prove a quick success in the market; give it a reasonable time to work out.

Demanding immediate success invariably leads to playing the fads or fashions currently performing well rather than investing on a solid basis. A course of investment, once charted, should be given time to work. Patience is a cmcial but rare investment commodity. The problem is not as simple as it may appear; studies have shown that businessmen and other investors abhor uncertainty. To most people in the marketplace, quick input-output matching is an expected condition of successful investing.

On Shark Attacks and Falling Airplane Parts

What is a more likely cause of death in the U.S.: being killed by a shark or by pieces falling from an 1 1 ? Most people will answer that shark attacks are more probable. Shark attacks receive far more publicity than deaths from falling plane parts, and they are certainly far more graphic to imagine, especially if youve seen Jaws. Yet dying from

takenly tend to place high confidence in extreme inputs or outputs. As we have seen, Intemet stocks in the mid-1990s were believed to have sensational prospects (the input), which was confirmed by prices that moved up astronomically-as much as 10- or even 20-fold (the output). The seemingly strong fundamentals went hand-in-hand with 8 1 rising prices for HMO stocks in the mid-1980s or for the computer leasing and medical technology stocks of 1968 and 1973. Extreme correlations look good and people are willing to accept them as reliable auguries, but as generations of investors have leamed the hard way, they arent.

The same thinking is applied to each crash and panic. Here the eamings estimates and outlooks (the inputs) erode as prices drop. Graham and Dodd, astute market clinicians that they were, saw the input-output relationship clearly. They wrote that "an inevitable mle of the market is that the prevalent theory of common stock valuations has developed in rather close conjunction with the change in the level of prices."" The consistency of this behavior leads us to our next contrarian mle:

falling airplane parts is thirty times more likely than being killed by a shark attack.23

This is an example of availability, a heuristic which causes major investor errors. According to Tversky and Kahneman, this is a mental rule of thumb by which people "assess the frequency of a class or the probability of an event by the ease with which instances or occurrences can be brought to mind."

As with most heuristics, or mental shortcuts, availability usually works quite well. By relying on availability to estimate the frequency or probability of an event, decision-makers are able to simplify what might otherwise be very difficult judgments.

This judgmental shortcut is accurate most of the time because we normally recall events more easily that have occurred frequentiy. Unfortunately, our recall is influenced by other factors besides frequency, such as how recentiy the events have occurred, or how salient or emotionally charged they are.* People recall good or bad events out of proportion to their actual frequency. The chances of being mauled by a grizzly bear at a national park are only one or two per million visitors, and the death rate is lower. Casualties from shark attacks are probably an even smaller percentage of swimmers in coastal waters. But because of the emotionally charged nature of the dangers, we think such attacks happen much oftener than they really do.

It is the occurrence of disasters, rather than tiieir probabilities of happening, that has an important impact on our buying of casualty insurance. The purchase of earthquake and airUne insurance goes up sharply after a calamity, as does flood insurance.

As a result, the availability rule of thumb breaks down, leading to systematic biases. The bottom line is that availability, like most heuristics, causes us to frequentiy misread probabilities, and get into investment difficulties as a result.

Recency, saliency, and emotionally charged events often dominate decision-making in the stock market. Statements by experts, crowd participation, and recent experience strongly incline the investor to follow the prevailing trend.

In the 1990s, small-capitalization growth stocks rocketed ahead of other equities. By early July 1996 this was almost the only game in town. The experience is repeated and salient to the investor, while the disastrous aftermath of the earlier speculation in aggressive growth issues in the sixties, seventies, and eighties has receded far back into memory.

The tendency of recent and salient events to move people away from the base-rate or long-term probabilities cannot be exaggerated. Time