In World War II at the Battle of Samar, a task force of small US escort carriers and destroyers suddenly found itself facing an enormous Japanese fleet including the world’s largest battleship the Yamato. Completely outgunned, and without enough speed to outrun the enemy, it looked like the Task Force was guaranteed to be completely destroyed. As shots from Yamato’s huge 18 inch guns started to straddle one the carriers, an Ensign said with false eélan, “Don’t worry boys, we’re sucking ‘em into range. We got 'em right where want ‘em now[1]”.
Sometimes successful value investing takes a certain form of bravado like our aforementioned naval ensign. But this type of enthusiasm can easily cross the line from supreme confidence to delusional thinking. Successful investors see that line quite clearly. Many unsuccessful investors cannot distinguish between the two.
How does one make a clear distinction between the two? How many of us have let our preconceived notions - or worse our emotional need - drive our investment decisions? It happens to all of us. I remember in my younger days estimating growth of X% for a company I admired. Later that afternoon I met with my partner to review my findings. His one comment was that my growth projections were double the historical rates of the corporation’s past 33 years. When eyed with a reptile-like steely gaze, my assumptions resembled Samuel Johnson’s definition of a second marriage - “a triumph of hope over experience”. Adam Smith pointed out that sometimes you provide information in a way to support your thesis (“The company growth will provide dramatic value over time”) or as a means to blame your holding for poor results (“It’s not my fault management blew the new product launch”).[2]. What is most frightening in this case was that I either simply didn’t recognize a potentially bad investment or I had fooled myself into thinking it was a great company with high growth rates. Neither of these would likely lead to a successful investment strategy.
My mistake is quite common in the investing world and is known as optimism bias. Investors project estimates that will fit with their investment thesis and have a tendency to disregard information contrary to their investment outlook. This type of thinking can lead to devastating results. Many individuals (and professional money managers) simply could not accept the fact that in 1999-2000 technology spending growth had to drop dramatically. Even more importantly, many were simply unable to question analysts’ estimates that were later proven wildly inaccurate - and in some cases – grossly unethical.
As usual Michael Mauboussin captured the problem in a clear and concise manner. He states that insider optimism is susceptible to “anecdotal evidence and fallacious perceptions.” In this case, insider doesn’t refer to a company insider, but rather to an individual who looks inwardly for confirmation. He goes on to say that outside thinking “asks if there are similar situations that can provide a statistical basis for making a decision. Rather than seeing a problem as unique, the outside view wants to know if others have faced comparable problems and, if so, what happened. The outside view is an unnatural way to think, precisely because it forces people to set aside all the cherished information they have gathered.”[3]
The Children of Lake Wobegone
A 2006 study by Dresdner Kleinwort Wasserstein Macro Research[4] makes a compelling case that investment managers are not immune to optimism bias. In a survey of 700 US and foreign-based investment managers, individuals were asked whether they thought they were above average at their job. Roughly 75% of respondents felt they were above average, 24% felt they were average, and less 1% felt they were below average. Anybody with a high-school level knowledge of statistics knows these results cannot possibly be accurate. Nearly 25% of the individuals most likely suffer from optimism bias (and an inflated ego).
So what can we take away from this? The main point is professional money managers - with years of hard performance data - have convinced themselves they are mostly above average in the skill sets. Second, optimism bias can lead you far astray from the cold hard facts. Yes, you might have a genuine affinity for making successful decisions, but only if the data support you in your claim. Last, an optimism bias can lead to rejection of information (or lack of information per Smith’s theory) essential to making wise decisions.
Conclusions
The line between reasoned optimism and optimism bias can be mighty thin sometimes. The ability to make that distinction by applying outside thinking and data means you have a leg up on most other investors. Don’t get me wrong. There’s nothing inherently bad about having a cheery disposition, but an investment manager utilizing such an outlook can cost his/her investors dearly. Like our sailors at Samar, sometimes a certain amount of bravado is required. Just not in investment management.
I look forward to your thoughts and comments.
[1] The story of the Battle of Saran and the fight of Taffy 3 is an extraordinary story. You can read more about the battle in the book “Last Stand of the Tin Can Sailors”, by James D. Hornfischer.
[2] For a wonderful and modern look at Adam Smith’s theories you should read “How Adam Smith Can Change Your Life”, Russ Roberts, 2014
[3] Think Twice: Harnessing the Power of Counterintuition, Michael J. Mauboussin, Harvard Business School Press, 2009
[4] “Behaving Badly”, Dresdner Kleinwort Wasserstein, February 2, 2006
Sometimes successful value investing takes a certain form of bravado like our aforementioned naval ensign. But this type of enthusiasm can easily cross the line from supreme confidence to delusional thinking. Successful investors see that line quite clearly. Many unsuccessful investors cannot distinguish between the two.
How does one make a clear distinction between the two? How many of us have let our preconceived notions - or worse our emotional need - drive our investment decisions? It happens to all of us. I remember in my younger days estimating growth of X% for a company I admired. Later that afternoon I met with my partner to review my findings. His one comment was that my growth projections were double the historical rates of the corporation’s past 33 years. When eyed with a reptile-like steely gaze, my assumptions resembled Samuel Johnson’s definition of a second marriage - “a triumph of hope over experience”. Adam Smith pointed out that sometimes you provide information in a way to support your thesis (“The company growth will provide dramatic value over time”) or as a means to blame your holding for poor results (“It’s not my fault management blew the new product launch”).[2]. What is most frightening in this case was that I either simply didn’t recognize a potentially bad investment or I had fooled myself into thinking it was a great company with high growth rates. Neither of these would likely lead to a successful investment strategy.
My mistake is quite common in the investing world and is known as optimism bias. Investors project estimates that will fit with their investment thesis and have a tendency to disregard information contrary to their investment outlook. This type of thinking can lead to devastating results. Many individuals (and professional money managers) simply could not accept the fact that in 1999-2000 technology spending growth had to drop dramatically. Even more importantly, many were simply unable to question analysts’ estimates that were later proven wildly inaccurate - and in some cases – grossly unethical.
As usual Michael Mauboussin captured the problem in a clear and concise manner. He states that insider optimism is susceptible to “anecdotal evidence and fallacious perceptions.” In this case, insider doesn’t refer to a company insider, but rather to an individual who looks inwardly for confirmation. He goes on to say that outside thinking “asks if there are similar situations that can provide a statistical basis for making a decision. Rather than seeing a problem as unique, the outside view wants to know if others have faced comparable problems and, if so, what happened. The outside view is an unnatural way to think, precisely because it forces people to set aside all the cherished information they have gathered.”[3]
The Children of Lake Wobegone
A 2006 study by Dresdner Kleinwort Wasserstein Macro Research[4] makes a compelling case that investment managers are not immune to optimism bias. In a survey of 700 US and foreign-based investment managers, individuals were asked whether they thought they were above average at their job. Roughly 75% of respondents felt they were above average, 24% felt they were average, and less 1% felt they were below average. Anybody with a high-school level knowledge of statistics knows these results cannot possibly be accurate. Nearly 25% of the individuals most likely suffer from optimism bias (and an inflated ego).
So what can we take away from this? The main point is professional money managers - with years of hard performance data - have convinced themselves they are mostly above average in the skill sets. Second, optimism bias can lead you far astray from the cold hard facts. Yes, you might have a genuine affinity for making successful decisions, but only if the data support you in your claim. Last, an optimism bias can lead to rejection of information (or lack of information per Smith’s theory) essential to making wise decisions.
Conclusions
The line between reasoned optimism and optimism bias can be mighty thin sometimes. The ability to make that distinction by applying outside thinking and data means you have a leg up on most other investors. Don’t get me wrong. There’s nothing inherently bad about having a cheery disposition, but an investment manager utilizing such an outlook can cost his/her investors dearly. Like our sailors at Samar, sometimes a certain amount of bravado is required. Just not in investment management.
I look forward to your thoughts and comments.
[1] The story of the Battle of Saran and the fight of Taffy 3 is an extraordinary story. You can read more about the battle in the book “Last Stand of the Tin Can Sailors”, by James D. Hornfischer.
[2] For a wonderful and modern look at Adam Smith’s theories you should read “How Adam Smith Can Change Your Life”, Russ Roberts, 2014
[3] Think Twice: Harnessing the Power of Counterintuition, Michael J. Mauboussin, Harvard Business School Press, 2009
[4] “Behaving Badly”, Dresdner Kleinwort Wasserstein, February 2, 2006
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