Behavioural Investing: Beating The Conservatism Bias
Consider this. The year is 2010, and real estate development in your city is on in full swing. The ad jingles for new project launches promising you your dream home chime away ubiquitously; wherever you look, a new apartment complex is mushrooming. All your friends seem to have made a small fortune flipping their money in and out of “projects” in the past couple of years. You turn bullish and decide – ‘Hey, it is time to start looking’.
Naturally, it is going to take you some time to zero-in on your investment – it is a big decision, after all. However, in the months that you spend scouting for the perfect real estate investment to make, things change. There is a massive build-up of leverage across the board, several projects stall, rental yields start correcting, and unsold inventory starts piling up. In other words, there are clear and present signs of an impending hard landing for real estate. Would you pause and reconsider your decision, or simply power through with your purchase?
At around the same time, the Nifty has just make a low of 4624 points in December 2011, after having heroically recaptured it’s previous high of 6300 barely a year back. Much to your chagrin, your portfolio of stocks is deep in the red. Newspapers merrily sensationalise the daily corrections, and so-called experts cry ‘doomsday’ – disregarding the fact that the index now trades at 17 times current earnings – significantly lower than its long-term average of 20 times. Some beaten down stocks now trade at bargain basement prices. Would you, in your firmly established bearish mind frame, bravely indulge in some bottom fishing?
Here is the most probable scenario. Despite the evidence pointing you in the opposite direction, you would most likely wind up booking losses in your stock portfolio and making a handsome down payment for a piece of real estate that would be flailing even five years later. In the meantime, the bellwether equity index would double as you sat on the side-lines, spawning a new generation of multi-bagger stocks.
What exactly happened here? You displayed a classic behavioural fallacy – the “conservatism bias” – the tendency to cling steadfastly to a prior viewpoint, even in the face of new information. So, you were a ‘perma-bull’ when it came to real estate, and a ‘perma-bear’ when it came to stocks. So, you hopped aboard the wrong bus. The facts changed, but you didn’t change your mind.
Ward Edwards, often referred to as the father of behavioural decision making, concluded in his landmark 1968 study that “it takes anywhere from two to five observations to do one observation’s worth of work in inducing a subject to change his opinions”. Put simply, most people severely under-react to facts that should make them change their minds.
In many ways, the crash of 2008 was a case study in financial conservatism. As most global economies fell into the clutches of a deep recession, the perma-bulls continued to throng the stock markets – IPOs and NFOs continued to roll in the face of unsustainable market valuations, and the party continued unabated. What happened next will forever remain a tragic chapter in the history of investing.
How To Overcome It
Even the smartest people in the world tend to exhibit biases in judgements and decisions, and it is foolhardy to believe that they can be overcome by the sheer force of will. The roots of conservatism actually lie in a more powerful behavioural bias known as the ‘sunk cost bias’. In this particular example, the months of time and effort spent in researching real estate amounted to a sunk cost that needed to be written off – this wouldn’t have been an easy task by any means, and could even have been heart-breaking.
The best way to overcome the conservatism bias with respect to investing would be to set up and doggedly adhere to a ‘trip wire’ checklist for every asset class – be it equities, real estate, gold or fixed income. List down the top five factors that you believe should drive your decision to invest or not invest. For real estate, it could be unsold inventory and QTS (quarters to sell). For equities, it could be the P/E ratio of the index, in tandem with its P/BV and Market Cap to GDP Ratio. For high duration debt, it could be underlying interest rates, in conjunction with inflation outlook and the general stance of the monetary policy committee. Keeping your emotions aside, allow your go/no-go decision to ‘trip’ based on changes in any or all of your checklist points.
It might surprise you to discover that Michael Steihnardt, legendary hedge fund manager and founder of Steinhardt, Fine, Berkowitz & Co, goes a step further and periodically wipes his slate clean by liquidating all his holdings in one shot. Although this is an extreme example of investment catharsis, it goes on to demonstrate a disciplined, albeit a tad maverick, approach towards breaking free from our preconceived notions on a periodic basis. “Sometimes, it felt refreshing to start over, all in cash”, writes Stienhardt in his autobiography No Bull: My Life In and Out of Markets.
Awareness is key. Begin by asking yourself if you are being a perma-bull or a perma-bear for any asset class right now. Evaluate your mindframe in light of facts that may have changed since the time that you took on your current point of view. Understand that hanging on to a view, simply because it’s “your view” is likely to end up causing you much grief. Investors, beware of the conservatism bias!
