When probability is all in the mind
Mental shortcuts such as availability heuristics are a form of bias which can lead to serious financial mistakes. Take Facebook’s disastrous initial public offering in 2012, for example
Here is an investment pop quiz: quick, what company comes first to mind that has gone public since 2000, and performed brilliantly well? If you said ‘Google,’ you are like most people, says Terrence Odean, professor of finance at the Haas School of Business, University of California. (You might also have mentioned Mastercard, PetroChina or CNOOC, but you probably did not.)
Now think of another initial public offering, also since 2000, of a company that went bankrupt, or seriously floundered. You probably hesitated quite a while, before coming up with, say, MF Global Holdings or Genworth Financial. Our quiz illustrates how investors use an availability heuristic as a shortcut for estimating how easily examples come to mind, and predict the future accordingly.
It often works, but not always.”Many people, overestimating the probability of success, called their brokers to get them Facebook stock,” Odean observes, citing the IPO that flopped in May 2012, and went on to lose half its IPO value in three months. Individual investors in IPOs tend to think about Google, rather than dwelling on those departed firms in the corporate graveyard.
In a 2006 article, “All that Glitters,” Odean discussed how investors buy attention-grabbing stocks that have been highlighted in the media (although they mainly sell what they already own). That bias toward familiarity is a slight variation on the availability mechanism.
Peter Lynch, bestselling 1980s author and celebrity manager of the Fidelity Magellan fund, encouraged his disciples to buy companies whose products they knew and understood. “There are no studies to suggest that practice makes you a better investors, but it makes you a more comfortable investor,” comments Hersh Shefrin, professor of finance at Santa Clara University.
Shefrin evokes the height of the dotcom era, when Paul Sagawa, a well-regarded telecom analyst was rating Palm shares an ‘outperform’. “It was hard to see how the valuations at the time supported the current price,” Shefrin recalls.
Sagawa, however, announced how his wife and all her friends were besotted with their Palm Pilots, and he deduced in November 2000 that the gadget would be a “red-hot item for Christmas”, with enormous upside. By 2010, Palm had died as an independent company, and was finally laid to rest in that investment graveyard.
Fighting the last war
Investors who were burned by the 2008 credit crisis are still nursing those wounds. Some withdrew their money from long-only equity funds, replacing those investments with hedge funds and private equity. As markets have continued to rally vigorously since 2009, some late to the party are now eager to enjoy solid returns again, albeit while taking more modest risk.
Brian Bruce, CEO of Hillcrest Asset Management, recently witnessed the availability heuristic at play, as he noted investment managers flocking to embrace low volatility strategies. Bruce was attending the Super Bowl of Indexing conference, an annual event held in Scottsdale, Arizona. This past December, he stopped by at a breakout session focused on those protective approaches. It piqued his curiosity that every seat had been taken, the walls were lined, people sat on the floor and even crammed the hallways, listening in. He immediately thought, “bubble.”
So Bruce compared performance in the S&P 500 index to that in the S&P low volatility index, which is dominated by more defensive stocks with higher dividends. The latter, he discovered, has indeed outperformed since 2008, but for two particular reasons. Firstly, annual turnover in the S&P index is only about three to four percent, whereas the low volatility counterpart is reconstituted quarterly. Those trading costs are not being taken into account. Secondly, low volatility returns have been lumpy, especially over a 20-year horizon, which includes the aftermath of the crashes after 2000 and 2008.
In other words, today’s money managers are speaking out of both sides of their mouths, and availability biases are prompting them to make decision errors. On one hand, they are acknowledging that we appear to be in a recovering economic environment, and that portfolios require cyclical equities to grow with the economy. Instead of following that logic, by investing in technology, healthcare or energy, they are plowing into consumer staples and utilities, which are likely to underperform in an expanding economy.
“They should have broadly based portfolios in all economic sectors, instead of concentrating on the most defensive,” says Bruce.
Availability heuristics can also distort capital budgets for both corporate outlays and public spending. Here’ is one last quiz question: what was the most fatal natural disaster in US history? The answer is a storm in Galveston Texas, during which about 10,000 people died in a case of overconfidence and vulnerability. In 1900, Galveston was booming during a generally optimistic epoch. “A brilliant meteorologist at the U.S. Weather Bureau had argued against putting up a seawall,” says Shefrin.
A century later, in 2005, Katrina proved the costliest-ever natural disaster in US history. “I don’t think anyone anticipated the breach of the levees,” said President Bush on 1 September 1 2005. That is untrue. In fact, the year before Katrina, emergency organisations had conducted a simulation exercise, nicknamed Hurricane Pam, to assess preparedness.
Over five days, volunteer organisations joined emergency officials to calculate the impact of 120 mph winds and a storm surge topping the levees. After the Pam exercise, a FEMA spokesman predicted that, “we would see casualties not seen in the United States in the last century.” Tragically, the 2004 scenario compounded the dangers, by focusing on recovery plans rather than preventative measures.
Although a follow-up simulation was planned for the summer of 2005, it was cancelled for lack of funding. Before Katrina struck, FEMA was aware that the levees were structurally unsound and the Corps of Engineers had requested $22.5m to repair them. Congress approved only $5.5m, since “the Bush administration said it had higher priorities, in dealing with terrorism and homeland security,” says Shefrin. The searing memories of 9/11 were still most readily accessible, again demonstrating how availability sways critical funding decisions.
Vanessa Drucker is the American Editor of Fund Strategy, based in New York City.