Biases Part II: What Corporations Can Learn From Behavioural Finance

On Dec 19, 2011, I wrote about this topic. Here is a follow up on this matter. Our goal is to look into the toolbox of Behavioural Finance, understand the biases they talk about, carry the toolbox from its place in finance into the world of corporations and enterprises, and see what the key bits mean in that every-day context. Indeed, it has meaning in Joe Blogg’s big company as well as in his private life, as private life is sort of an enterprise in itself.

Last time, we did a tour through what may go emotionally wrong; in focus were emotional biases. This time we look into what may obstruct people’s straight line to success because of i) malfunctioning CPUs and memory chips and overly high access time to the RAM (old hardware I suspect) and ii) flawed software – all in the brain. The focus is on cognitive errors or biases.

The bad news is that people are subject to lots of cognitive errors. Faulty brain software is at work all the time. This should come as a surprise, as we know pretty well how good and smart we all are. Anyway, not to be sad. The good news is some of this faulty brain software code can be repaired, the biases can be corrected, easier than the emotional biases I mentioned last time.

By the way, several of these cognitive biases have to do with reasoning along the lines of least resistance, taking a heuristic, applying a rule of thumb or a mental shortcut. Some have to do with how humans take in information (all these newspapers, the endless data hose pipe of the Web, the books from great Amazon, the rumours and the gossip, the daily dose of TV etc.) and classify it so at least some bits become storable in memory and later easily retrievable. Some software in the brain, though a first class piece of work without any doubt, is actually bent towards malfunctioning by a far more powerful master of the daily thinking ceremony, our system of beliefs. Beliefs are like celebrities: they want to be entertained and need attention and followers. Left in the cold they will soon come back, angry or hysterical, ready to interfere. A belief is also like a coin: a charismatic leader and coach on the one side that steers you to personal success, and a little tin dictator on the other side that causes mental discomfort and cognitive dissonance every time some new information conflicts with it.

Wake up in the morning and start to get your daily dose of information. Everything in line, the system of beliefs is fine. Something out of step or in conflict with it, the system of beliefs applies various tricks for the purpose of staying in power, unchallenged. Back in 2000: You strongly believe that money is important. You pick up the newspaper, and your belief makes you notice all the headlines that are of interest to you: “Buy now, tech shares going even higher!” It also makes you not noticing the smaller articles on the opinion page, saying “Hang on guys, seems like a mega bubble is developing, get out now.” Our belief interferes with our brain software to make it filter out the unwanted information (heck!). Experts call this selective exposure. Assume one tiny headline has cheated its way into your brain: “Every stock bubble bursts at 12:00. We are now at the eleventh hour. Take your gains and leave the casino.” Again, our belief interferes, hijacks the information and fiddles around with it, to make it sound like: “Every stock bubble bursts at 12pm. We are now at the eleventh hour am. Get more chips and stay in the casino.” That’s what experts call selective perception. Seeing the dotcom bubble still in full swing, your best friend is asking you: “Shall I invest in the stock market as well?”. You dig up what you stored in your memory over the last 7 days, and all you can produce is evidence for stocks going higher and higher. All warning headlines have never made it into your long-term memory. That’s what experts call selective retention.

Beliefs are strong companions, but equally they fool us every day. After the theory, now some practice. Only looking at a few bad boys…

Confirmation Bias: That’s when people look for and eat information which confirms a belief, and ignore pieces of information which contradicts that belief. Assume Joe Bloggs is invested in Apple shares. He believes that’s a great company and concludes that therefore it’s a great investment. His brain welcomes information about long excited queues in front of Apple stores, it picks up good news bites about Apple on the Web but it gets diarrhoea when it comes across a statement saying that a great company is not necessarily always a great investment, or that the stock is overvalued, or its momentum is going to decline.

Think Joe is a product manager for a new online game, and a passionate game player himself. He has a budget, resources and some time to bring it to market. After that is all consumed and the game is still not yet on the market, his bosses will pull the plug. When Joe oversees a project review meeting, his attention focuses on 50 powerpoint slides of game features, competitors’ products, sales channels, pricing strategies, and good-looking business case figures. The page modestly titled “Risks” is with all likelihood filtered out by his brain. “According to what you showed me guys, we are on track”, he says. Confirmation bias.

Representativeness Bias: Equally it twists the code in our (usually so) reliably working mental software. Get a piece of new information. Where to store it in your memory? Front seat? Back seat? Corner office? Broom cupboard? Well, just classify the new information based on what you know from past experience and based on all the mental classifications you have made up over time. Assume Joe were given another chance to invest in Enron. “Hmm, looks like a growth stock. Earnings per share increasing all the time, stock price moving up from left to right like a chair-lift, people like it, it’s in the news as well. Done deal. Buy 200 shares.” Enron shares look like representative for a growth stock. That’s the classification system at work. But hey, is Enron actually a growth company? Well, now with hindsight, we know better. Actually not. Joe’s shortcut mental classification system was a bit too much of a shortcut.

Let’s try another example. US central back versus European central bank. The US Fed, apparently free of this bias, has been printing electronic dollars as freely as never before (see quantitative easing). The Europeans (the rumour has it at least the careful German representatives) these days dislike printing money to save the banks, the Greek, the Portuguese, the Spanish, the Italians, the all of us. Printing lots of electronic money in 2012, what does this concept mean? Well, that may best fit to an inflation frame of reference in a European central banker’s mind. There were times in Europe where printing money led to hyperinflation. Want to buy a USB stick and have to drive up with a lorry of bank notes in front of PC World (well, they didn’t have USB sticks at the time). Printing money is representative for sowing the seeds of high inflation, though it doesn’t need to end in that. Representativeness bias at work.

Hindsight Bias: Things look pretty simple when considered with hindsight. Really surprising that the dotcom bubble burst in 2001? No. Surprising that the MBS, CMO, CDO sausage factory brought the financial system to a halt in 2008? No. With the benefit of hindsight, it appears quite logical. Assume in 1999 you magically got cold feet and predicted to a friend that this high tech stock bubble would burst within one or two years. At the time, your prediction was pretty uncertain and inaccurate, predominantly a gut feeling. Today you would remember your famous prediction as ‘spot on’. Now it looks very accurate. Hindsight bias, a well-meaning ego caressing companion, has substituted the origin of your past prediction, your guts, by the knowledge and understanding you have accumulated since 2000 about why this bubble had to burst there and then. The real issue: Once a past event you roughly predicted has actually occurred, and hindsight bias fools you into thinking that you understood it all at the time, then you will tend to predict similar events more confidently or consider them as more likely to happen.

Our online games product manager Joe goes to the next project review meeting. It’s the first time, the CEO will show up and scrutinise the project. Joe’s guts tell him this meeting may go terribly wrong. Though the new game comes with a great sales forecast, its predecessor is overdue to be replaced and the online community is eagerly awaiting the new release, it has its issues with profitability (well, many do, don’t they). The CEO may sink the ship because of the financial figures. And Joe’s prediction comes true. The CEO pulls the plug and the project is put to rest in peace. Only over the next weeks it transpires that a far bigger, important development project has run into serious trouble and needed the brightest employees and extra resources to bring it back on track. With hindsight no wonder they sank Joe’s smaller project. Since then, every time there is a rumour of big-project-trouble going round the office and Joe has to present at a decision meeting about his own small-cake project, he gives up before he even enters the meeting room. It will go wrong; they will sacrifice the little project for the sake of the bigger dinosaur. He makes that prediction with a firm belief which just takes all fire and enthusiasm out of his presentation. A month later he will say: “I knew it all along.” Trapped in hindsight bias. Mind, alternatively this bias leads to lots of overconfidence, when events were predicted to turn out well and later they indeed materialised.

Many more of these cognitive biases exist. No shortage of them! However, not all have room on this page. Let’s address a final one, a very widespread one indeed.

Mental Accounting: In Behavioural Finance it e.g. means that people don’t apply an integrated asset allocation over all their investment portfolios as modern portfolio theory would advise. Instead they think in terms of separate accounts for separate purposes. Joe invests some money in government bonds for retirement; little risk (think normal times, not 2011!). He keeps some other funds with a discount broker to manage an equity portfolio to fund his children’s education; riskier investment. Any birthday cash gifts from his family he mentally places into his “speculation allowance” account and promptly gambles it away within 7 days; very risky, good man. In finance this is not ideal as it likely leads to inefficient and undiversified portfolios. Overall, money is placed into different mental accounts, some with low risk, and others with high risk. Because of the total separation, the overall risk exposure is a pure guess. Joe wouldn’t know how close he is to his desired risk exposure.

How would mental accounting work outside finance? Let’s consider health, eating and drinking. Food and drinks are like cash: we can place it into mental accounts and then think about it in separate ways, thereby losing oversight over our real objective. Say, Joe comes up with a New Year’s promise to shed 5 kg of weight. That’s his goal. The mental accounting then takes up its work:

Breakfast is cereals only – purpose: good for digestion. Lunch is fresh salad only to slim down. This is cornerstone 1 of his weight-loss strategy. Dessert is creamy yoghurt, a small chocolate cake or a slice of shortbread. Dessert is dessert. It’s a dedicated account. Everybody takes a dessert. A man without dessert is no man. After work three pints of beer – the reward for the day and the vast majority of co-workers expect you to join in for a drink. A man with just a pint is a wimp. Only a man with at least 3 pints is a man. That’s tradition, its own account. Dinner with family, roasted chicken with a rich sauce, fried potatoes with tomato ketchup – the school boys had a long day and they are as hungry as lions. Also, in this house everybody eats what comes on the table. Wednesday friend’s birthday party: cake (only a small one) and coffee. Friend’s don’t take your slimming-down-excuse serious anyway. Thursday evening, the town mayor’s dinner speech: Need to tuck in as everybody else; cannot stare at an empty dish in front of me. Saturday is fitness day and holy cornerstone 2 of Joe’s weight-loss strategy: Time for an energy drink and 10 miles on the jogging machine. Oh, then the festive season arrives with turkey, stuffing and much more. That’s a one-off and an untouchable account. So it goes. Where is Joe overall with his objective across his mental accounts? Mental accounting with investment portfolios and with the food story above have in common that cross-account effects are ignored. This makes it very difficult to forecast the overall effect, whether its portfolio risk or progress with a health objective.

So then, exhausted we are, battered by the machinery in our brain, thoroughly impressed how beliefs can make us fools and how we can fall victim of cognitive biases and errors so easily. Above is not even the full list of cognitive biases. To serve more would be far too much. Anyhow, as already mentioned: These biases are remarkably important in finance. Rediscovering them outside finance and identifying them on a day-to-day basis is also quite fascinating.

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