Strategy Insight: Errare est Humanum

April 28, 2020
Chief Investment Strategist Scott Clemons shares why maintaining a disciplined investment approach can help overcome the behavioral biases that a crisis often brings.

“To err is human,” observed the Roman philosopher Seneca the Younger. Behavioral psychologists in the 21st century have not only proven that this ancient adage is true, but have furthermore demonstrated that we err in predictable and repeatable ways, and that these errors are exacerbated when we make decisions in periods of heightened uncertainty and stress. Uncertainty and stress are the twin watchwords of all our lives right now, as we work and learn from home, are anxious about our own health and finances, worried about a timeline for returning to more normal activities and wondering when that might begin to happen. This is a ripe environment for the cognitive shortcuts that behavioral psychologists call heuristics – innate mental models that can lead us astray without even knowing it.

This is not a sign of sloppy thinking. Behavioral biases related to decision-making are hardwired into our DNA and helped the human species survive. Making a quick decision when confronted with danger was literally a lifesaver in prehistoric times. If our ancestors had paused to systematically determine whether the sharp teeth on a certain wild animal actually posed a threat or not, we would not be here today. The problem arises when we allow this intuitive and reflexive thought process to dominate when a situation calls for disciplined analytical thought.

Two specific and common heuristics are particularly prevalent in the world of investing: anchoring and the overconfidence bias.

Anchoring is the tendency to base an estimate or belief on a known starting point and then adjust relative to this starting point, even if the anchor isn’t as stable or relevant as it should be. When we form an opinion about something we don’t know, our instinct (the heuristic) is to start with something we do know (the anchor) and then adjust from there to arrive at an estimate of the unknown quantity. This is not a conscious exercise: The whole point is that our automatic thinking takes over without us knowing it. The problem is that we instinctively place too much reliance on the anchor and then adjust inaccurately from that position without realizing it.

Two specific and common heuristics are particularly prevalent in the world of investing: anchoring and the overconfidence bias.

As a simple example, how would you arrive at an estimate of how many days it takes Mercury to orbit the sun? Short of being an astronomer (or googling it), you instinctively start with something you do know – how long it takes Earth to orbit the sun – and then adjust from there, although we often adjust inaccurately. (The answer is 88 days.) For fun, guess how many days it takes Neptune to orbit the sun using this same sort of anchoring and adjusting heuristic, but don’t google the right answer just yet.

In this planetary example, the anchor is relevant and readily known. Here’s the scary part: Researchers have shown repeatedly that even when the anchor is random or irrelevant, it still influences or even dictates our thinking. In one study, participants were asked to write down the last three digits of their Social Security number, add 400 to the figure, and then estimate the year in which Attila the Hun was defeated and forced out of France. There is no rational relationship between your Social Security number and early European history, but in this study, the correlation between randomly generated anchors and the participants’ guesses was 97%. The higher the random anchor, the higher the guess just about every time.

Anchors are everywhere: the asking price for a house or new car, the performance of a stock or index year to date, vs. a 52-week high or since the coronavirus crisis began, the number of newly diagnosed COVID-19 cases, and so forth. How many stories have you read comparing our current circumstance to the H1N1 crisis of 2009 or the Spanish flu pandemic in 1918? All historical anchors. We are a pattern-seeking species. We look for patterns and anchors to help us make sense of the present, and there is nothing inherently wrong with this. After all, the answer to a simple question such as “How is my portfolio doing?” requires an anchor.

The problem arises when we rely on a single anchor, or worse, an irrelevant one. The fact that a portfolio is up or down vs. a benchmark over a particular time period may be irrelevant to the long-term goal of wealth preservation or creation. Our investment process at Brown Brothers Harriman (BBH) relies on anchors, but we consciously anchor our investment decisions on the relative durability of intrinsic value instead of the volatility of price, and we take a range of value anchors into account, not just one.

The problem arises when we rely on a single anchor, or worse, an irrelevant one.

There is no antidote for the human tendency to use (and abuse) anchors, other than to be aware of when you are relying on this heuristic, and then considering carefully the relevance of anchors, allowing multiple anchors to dilute the influence of any single reference point.

A related mental shortcut is overconfidence bias. We like to be right, and therefore place too much confidence in the accuracy of our own judgments. The overconfidence bias is essentially a psychological restatement of something our mothers always told us when as children we got too big for our britches: “You’re not as smart as you think you are.” We’re still not. We tend to place too much confidence in the accuracy of our own judgments, opinions and beliefs, and additional information is likely to increase that confidence, even if it was poorly supported in the first place. We naturally look for confirming evidence of what we “know” to be true, and discount or even ignore contradictory information. Or, as articulated more elegantly by those two great American philosophers Paul Simon and Art Garfunkel, “Still a man hears what he wants to hear, and disregards the rest.”

Researchers test this bias by having subjects provide a range of estimates on quantitative questions on a variety of subjects. The purpose of this testing isn’t to gauge actual knowledge, but to demonstrate how, in our desire to be right, we wind up overconfident. Ranges of estimates in experiments like this are invariably too small. Go back to the question of how long it takes Neptune to orbit the sun. Instead of anchoring and adjusting to an answer, think instead of a low and high range so that you’re 90% confident (and that’s pretty sure) that the right answer falls within your range. Most of you will come up with a range that is far too narrow. (Now you can google the answer.)

A bias toward confirming evidence feeds overconfidence. You may read a particular proposal for reopening the economy post-COVID-19 that agrees with your own opinion, and you naturally (and subconsciously) think more highly of the author. After all, she agrees with you (and confirms your opinion), so she must be smart. Another article which challenges your conclusion is readily dismissed as coming from an economist at a second-rate college, and what does he know about the practical challenges of running a business anyway? The fact is, these things take place automatically, below the surface of consciousness. Again, these aren’t signs of mental impairment or poor thinking! Just evidence that we are all too human.

We are accustomed to thinking of probability and uncertainty in bounded terms. The classic analogies for taking a chance on an unknown outcome are flipping a coin or rolling a die. Yet life doesn’t look like these simple models, where the range of potential outcomes is known in advance. In the real world, we don’t know how many sides the die has or what is on them. If the coronavirus crisis has taught us nothing else, it has proven that many probabilities lie beyond the realm of our imagination.

The investment universe is replete with examples of the overconfidence bias. Turn on any financial news network, and someone will be telling you that they’re sure that the market has formed a bottom. Wait 10 minutes, and the next guest will, with equal confidence, lay claim to the opposite opinion. Unwarranted confidence in the direction of a stock or the overall market has been the undoing of many an investor. The belief that the market has bottomed, confirmed by every day that it inches higher, leads you to ignore evidence that risks still abound. Or, vice versa, the litany of bad news crawling across your television or phone convinces you that there is more pain to come and that the overoptimistic managers talking about investment opportunities are turning a blind eye to reality. The point is that all these seemingly contradictory things can all be true at once: It’s just hard to hold them all in your head at the same time without allowing one or the other set to confirm a conclusion that you’ve already reached without realizing it.

As with the anchoring bias, awareness is the best antidote to overconfidence. Acknowledge the other side of an argument, and actively seek out contradictory evidence to what you believe to be true. This doesn’t imply that you have to change your mind every time you encounter a conflicting piece of information – far from it. Dealing honestly and fairly with conflicting information makes you a better thinker (and investor), not a weaker one.

As with the anchoring bias, awareness in the best antidote to overconfidence.

The investment process at BBH incorporates the risk of overconfidence by insisting on a margin of safety in any investment we make. Buying an asset at a discount to its intrinsic value acknowledges that there may be developments outside our range of expectations (say, for example, a pandemic) that could impair the fundamental value of the asset. Incorporating that uncertainty into an intrinsic value estimate, and then insisting on paying a discount to that estimate, is one way to mitigate the risk of the unknown. We further address the risk of overconfidence through portfolio diversification. We believe in concentration as a way to know what we own and why we own it, but this concentration is balanced out by prudent diversification that acknowledges that we can’t know everything with certainty. Finally, peer review lies at the core of all of our investment solutions. Challenging someone else’s thought process, and in turn being willing to be challenged, is the hallmark of a robust decision-making process.

“Doubt,” mused Voltaire, “is an unpleasant condition. But certainty is absurd.” Human nature abhors uncertainty and ambiguity, and in doing so can lead us to become our own worst enemy when it comes to making decisions. This challenge becomes more acute in periods of stress and heightened insecurity. A disciplined investment approach is important in any financial environment, but is critical in an environment like now.

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