Shortcuts to Disaster

We find, then, that the information-processing shortcuts-heuristics- which are highly efficient and timesaving in day-to-day situations, work systematically against us in the marketplace.

Only in recent years has it been recognized that people simply dont follow probability theory under conditions of uncertainty. The implications of these cognitive biases are enormous, not only in economics, management, and investments, but in virtually every area of decisionmaking. The tendency to underestimate or ignore prior probabilities in making a decision is undoubtedly the most significant problem of intuitive prediction in fields as diverse as financial analysis, accounting, geography, engineering, and military intelligence."

Cognitive biases, which affect each of us to a greater or lesser extent, are locked more firmly into place by the group pressures described earlier. When our own cognitive biases are reinforced by the powerful influence of experts and peer groups we respect, and who interpret information in the same way, the pressure to follow becomes compelling.

Its important then to have some protective rules against the tug of prevailing fashion. Lets briefly review the five rules weve looked at in this chapter:

RULE 22

Look beyond obvious similarities between a current investment situation and one that appears equivalent in the past. Consider other important factors that may result in a markedly different outcome.

RULE 23

Dont be influenced by the short-term record of a money manager, broker, analyst, or advisor, no matter how impressive; dont accept cursory economic or investment news without significant substantiation.

RULE 24

Dont rely solely on the "case rate." Take into account the "base rate"-the prior probabilities of profit or loss.

RULE 25

Dont be seduced by recent rates of return for individual stocks or the market when they deviate sharply from past norms (the "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.

RULE 26

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

Frankly, the above rules are going to be a lot harder to follow than you think, because the cognitive biases are anything but phantoms. They can reveal a dozen reasons why you should abandon a course, naturally all expertly masking the real motives for doing so.

Other work in cognitive psychology indicates that even when people are warned of such biases they appear not to be able to adjust for their effects. So it will take a good deal of concentration and effort on your part to avoid these pitfalls. However, the effort to understand their pull should prove rewarding and should help you avoid many a serious error.

Heuristic biases, interacting with other psychological forces, lead to consistent overreaction in markets. Lets next turn to how similar and predictable the psychology of overreaction is not only in the stock market but in other areas, from collecting art to investing in junk bonds.

11

Profiting from Investor Overreaction

vERREACTioN plays a part in virtually every aspect of human activity. When two North Vietnamese 1 (1 boats attacked a U.S. Navy destroyer, Congress gave President Johnson emergency powers that virtually abrogated their right to declare war. Historians now question whether the torpedo boats were remotely near the destroyer, or even at the scene. Yet, Congresss reaction was the major reason for the enormous escalation of the war.

Overreaction is almost a given in military thinking. After their ignominious defeat in the Franco-Prussian War of 1870, the French General Staff attributed the loss to lack of the dash and daring that had characterized French armies under Napoleon I. The marshals and generals overreacted by stressing elan above all else, even though there had been revolutionary changes in weaponry since Napoleons time. For 44 years afterwards, French military maneuvers concentrated on fixed bayonet attacks in closely packed ranks, the tactic that had won the Emperor victory after victory.

But 1914 was not 1812. When World War I started, the cream of the French army was slaughtered by the rapid precision fire of the German machine guns and the enormous destructive power of their artillery. The overreaction to the Prussian defeat resulted in 250,000 French dead in the first six weeks of the war alone, about the total number of American soldiers killed in action in World War II.