Wednesday, October 22, 2014

Two to five observations before changing one's mind...

The excerpt below is from James Montier in The Little Book of Behavioral Investing. One lesson from this is that if you get good at changing your mind quickly when the facts change, good at destroying your own best-loved ideas, and good and filtering and identifying truly important information, you can gain an advantage over others that may be looking at the exact same data. 
The classic study on conservatism (from which the urn example at the start of this chapter was drawn) concludes its analysis by saying: “A convenient first approximation to the data would say that it takes anywhere from two to five observations to do one observation’s worth in inducing the subject to change their opinions.” In other words, people underreact to things that should make them change their minds. That certainly seems to sum up the average analyst. 
I should also point out that it appears that people are particularly bad at spotting regime changes. Researchers have shown that in a series of experiments using urns like in the question above, people tend to underreact in unstable environments with precise signals (turning points), but overreact to stable environments with noisy signals (trending markets). This helps explain why economists and analysts tend to miss turning points in the market. They get hung up on the stable environment and overreact to it; hence they miss the important things that happen when the environment becomes more unstable (a recession starts) and underreact to such developments. 
Sunk Costs at the Root of Conservatism 
So why are analysts and the rest of us so reticent to alter views? What is the root cause of this conservatism? The answer seems to me to lie in the “sunk cost” fallacy. This is a tendency to allow past unrecoverable expenses to inform current decisions. Brutally put, we tend to hang onto our views too long simply because we spent time and effort in coming up with those views in the first place.