Tuesday, May 1, 2012

Five Things You Can Do To Counteract Irrational Bias

Are financial markets filled with rational investors? Before we even begin to look at the evidence, we know intuitively that this cannot be the case - the dot com boom and bust, the financial crisis of 2008, and Dutch tulips are but a few examples of the tendency to form bubbles that subsequently pop.
What are the implications for our dividend and financial strategy given that Perfect Capital Market Assumption #4 – Rational Investors and Markets – does not hold in the real world?

People are People
The reason that the Rational Investors and Markets assumption does not hold is simply the fact that all participants have one thing in common – they’re people!
And as people we are all subject to very human foibles (from a believer in economic rationalism, anyways) – acting on emotion, deciding based on our “gut”, honoring relationships, loyalty, tapping into our primordial instincts, etc. There is a long list of cognitive bias that we are subject to.

There is Safety in Numbers – and Risk!
One of our human traits is the herd instinct. We congregate into families, tribes and communities. We identify with various collectives of people – our city, our church, our profession, our company, our country. Hermits living in the woods are viewed as strange, abnormal folks.
A lot of the bubble-and-burst activity is tied to this tendency. Our friends buy tech stocks, talk about them at parties, and we call up our broker and order them the next day. Or our analyst buddies at XYZ are bullish on a stock, we become bullish too, which makes it easier to share a drink with them after work.
Yet, as Warren Buffet says - “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”. This quote points out the need to be the contrarian when it comes to financial markets. If you follow the herd you wind up running over the property value cliff, the dot com cliff, and the Dutch Tulip cliff.
The fact is, you need to run away from the herd in order to succeed.

Companies are People Too!
Companies are but an aggregation of people, and thus the same traits define them to some extent. Many companies exhibit the same irrationality that applies to individuals.
If your firm spends its time courting sell-side and buy-side analysts, it will end up thinking like these folks and seeking to deploy strategies that will satisfy this stakeholder group. Positive NPV? Not when the analysts are focused on Earnings Per Share (EPS)!
Another example is the timing of share repurchases. Research by McKinsey shows that companies on average are much more prone to buying near the top than the bottom. This is likely a combination of the overconfidence bias coupled with the social reinforcement firms receive from their analysts.

Five Things You Can Do to Counteract Irrational Bias
As an organization with the ability to harness the hearts and minds of our many constituents, we are in a position where we can counter-act the human tendency toward irrationality. How can we accomplish this?
Encourage alternative viewpoints through the culture – there are those within your firm that are able to articulate an alternative view of the facts quite different than the accepted norm. In order for these folks to come forward, a culture of awareness, tolerance, and acceptance are required. See here for additional information.
Encourage discovery through formalized process – the Catholic Church anoints a “Devil’s Advocate’ when it comes to determining sainthood. The role of this person is to present the strongest case possible that sainthood is not warranted. This role can be adapted to the strategic planning process and the capital investment allocation process. The key element is ‘immunity’ to those who play this role. See here for additional information.
Perform Introspective Activities – entrepreneurs are sometimes known for their “shoot from the hip”, “decide on the go” style. In order to avoid bias, however, there needs to be a capacity to reflect objectively on behavior without remaining anchored in the heat of the moment. See here for additional information.
Conduct a ‘Pre-Mortem’ – as part of a project planning or group implementation effort, participants can be asked to provide a ‘pre-mortem’ assessment of the effort. This is a twist on the “what do you want on your tombstone” exercise. However, rather than focus on the mission in life, members are asked to provide insight as to how things went wrong in the effort that ultimately made it unsuccessful. See here for additional information.
Learn How to Generate Feedback without the Herd – part of our tendency to follow the herd is that it provides immediate feedback - “They go left, I go left, therefore I am doing something correctly.” Develop benchmarks that are “Herd Independent”. Create your goals in the “vacuum of continuous improvement”. For example: “I know I did x with y this past year, so I am going to shoot for x with z (z being less than y) this coming year”. See here for additional information.

Key Takeaways
The tendency of human nature is irrational. It takes a lot of organizational initiative, structure, and willpower to overcome this, and for this reason organizations rarely attain this standard. This provides us with a golden opportunity.
Questions
·         What suggestions do you have for activities and processes that will enable an organization to overcome basic human irrationality?

Add to the discussion with your thoughts, comments, questions and feedback! Please share Treasury Café with others. Thank you!

2 comments:

  1. I believe that HFT is the industry response. I used to program for an automated trading system developer, and that was our flagship argument: "no emotion".

    However, I also believe HFT has created it's own "herd" with automated trading volume reaching 60% of all trading volume: http://www.automatedtrader.net/news/algorithmic-trading-%20news/78/program-trading-averaged-608-percent-of-nyse-volume-during-may-22_26

    Also, I believe that emotion at this particular time can provide an edge that would otherwise not exist. If the herd is itself "unemotional" than the contrary view is emotional.

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    Replies
    1. Richard,

      By HFT I believe you are referencing High Frequency Trading?

      Assuming a lot of the algorithms are similar, I think it would be correct to view this as a herd activity. One wonders where the cliff might be.

      The thing about bubbles is that they persist under the "Greater Fool" theory - you can buy something that is way overpriced so long as there is a fool greater than you who will buy it from you for more!

      Now if we can get that into an algorithm...!

      I like that twist as well - emotion is a contrarain strategy!

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